High earners who buy rental property often discover that the depreciation losses can't be used against their salary or practice income. The passive activity rules treat most rental losses as passive, and passive losses only offset passive income. But a property rented mostly for short stays may not count as a rental activity at all.
The seven-day test
Under the passive activity regulations, a property isn't treated as a rental activity if the average period of customer use is seven days or less. Average use is generally total rental days divided by the number of separate stays. Properties with average stays of 30 days or less can also qualify if you provide significant personal services, though that test is harder to meet.
That shifts the question from "Is this a rental?" to "Do you materially participate in this business?"
Material participation
If the property passes the seven-day test and you materially participate, losses are non-passive and can offset other income. The tests most owners rely on are:
- You spend more than 500 hours on the activity during the year, or
- You spend more than 100 hours and at least as much as any other individual, including cleaners and property managers, or
- Your participation makes up substantially all of the participation in the activity.
Hiring a full-service property manager often makes these tests impossible to meet, because the manager's hours exceed yours.
Pairing with cost segregation
The strategy becomes powerful when combined with a cost segregation study. Furnishings, appliances and many components of a vacation home can qualify for short recovery periods, and with 100% bonus depreciation now permanent for property acquired after January 19, 2025, a large share of the purchase price can be deducted in the first year.
Limits and pitfalls
- Excess business losses. Large non-passive losses are still limited each year by the excess business loss rule, now permanent. Disallowed amounts carry forward as a net operating loss.
- Personal use. Using the property yourself for more than the greater of 14 days or 10% of rental days can limit deductions under the vacation home rules.
- One year at a time. The tests apply each year. A year with longer average stays or less participation can turn losses passive again.
- Recapture. Accelerated depreciation is recaptured when you sell, often at ordinary rates.
- Local rules. Portland and many coastal and mountain communities require permits, limit short-term rentals or charge lodging taxes. Check before you buy.
Who it can work for
This strategy tends to fit high-income professionals who are willing to manage a property themselves, often with a spouse, and who can keep good records. It's less likely to work for someone who wants a hands-off investment.
The bottom line
A short-term rental can provide meaningful deductions against W-2 or practice income, but only with the right facts and documentation. We help clients test the numbers before buying, coordinate the cost segregation study and set up the records that support the position.
This article is general information, not tax, legal or investment advice for your situation. Rules and thresholds change, so please talk with a qualified advisor before acting.
