Real estate investors have long used cost segregation to accelerate depreciation and unlock tax savings. But for owners of short-term rentals (STRs), this strategy can go a step further—offsetting not just passive income, but ordinary income like W-2 wages or business profits. It’s made possible by a tax rule commonly known as the short-term rental loophole.

Here’s how it works—and why it’s so powerful.

What Is the Short-Term Rental Loophole?

Under normal IRS rules, rental income is considered passive. That means losses from your rental property—like depreciation—can typically only be used to offset other passive income. However, short-term rentals operate under a different set of rules.

If the average guest stay is seven days or less, the IRS treats the rental as a business activity, much like a hotel (IRS Reg. §1.469-1T(e)(3)(ii)(A)). This opens the door for short-term rental owners to treat losses as non-passive, provided they also meet certain material participation requirements.

Material Participation: The Key to Active Classification

To qualify for this loophole, you must materially participate in the rental activity. In plain terms, this means you’re actively involved in managing the property—not just collecting checks from a property manager.

You may qualify by meeting one of several IRS-defined tests. Some of the most common include:

  • Spending more than 100 hours on your STR business, and more than anyone else.
  • Spending 500+ hours annually on STR activities.
  • Being the sole person performing substantially all of the work.
  • Participating consistently for 5 of the last 10 years or providing significant services for 3 of the last 5 years.

Documenting your time is essential. Tasks like responding to guests, managing bookings, overseeing repairs, and handling cleanings all count toward your hours (IRS Reg. §1.469-5T).

Where Cost Segregation Comes In

Once your STR is classified as active, the real advantage begins: cost segregation. This is a tax strategy that breaks your property into different asset classes—such as flooring, furniture, appliances, and landscaping—that can be depreciated over 5, 7, or 15 years instead of the standard 39 years for commercial property or 27.5 years for residential (IRS Pub. 946).

By front-loading these deductions, cost segregation allows you to claim a larger portion of depreciation in the early years of ownership.

The Tax Impact: Offset Wages, Not Just Rental Income

Here’s why this matters: once you qualify for material participation, your STR losses—including accelerated depreciation—are considered active losses. That means they can be used to reduce your total taxable income, including:

  • W-2 wages
  • Self-employment income
  • Business profits

This combination—the short-term rental loophole plus cost segregation—can dramatically reduce your tax liability, especially in high-income years. Some investors have seen six-figure deductions in year one alone (ICS Tax: How Cost Segregation Can Widen the STR Loophole).

Things to Keep in Mind

Bonus depreciation is phasing down. While 100% bonus depreciation was available through 2022, it began phasing out in 2023 (dropping to 80%, then 60% in 2024, and 40% in 2025). That means it’s wise to act sooner than later to maximize deductions (Tax Cuts and Jobs Act of 2017). However, we may see a return to 100% first year bonus depreciation if H.R. 1, or the “Big Beautiful Bill” passes. This would bring back 100% bonus depreciation for STRs.

Real Estate Professional Status (REPS) is another way to achieve non-passive classification, but it’s harder to qualify for unless real estate is your full-time job.

Always consult a tax professional. These strategies involve complex IRS rules, and working with a CPA or cost segregation specialist ensures you remain compliant and fully optimized.

Filing Jointly

Often times, it can be very difficult for high earners to have time to manage an STR while maintaining their primary career. Savvy couples who file jointly have gotten strategic when it comes to taking advantage of deductions. When filing jointly, if one spouse can meet the requirements of Real Estate Professional Status, or Material Participation, the joint return can utilize all the deductions generated by the cost segregation study to reduce taxable income on a joint return.

Final Thoughts

Cost segregation is a proven tax tool. When paired with the short-term rental loophole, it becomes a high-impact strategy that allows STR owners to treat rental income like a business, capture accelerated depreciation, and offset active income.
If you’re considering purchasing or already operating a short-term rental, now is the time to explore whether you qualify—and what it could mean for your bottom line.

 
Sources
IRS Reg. §1.469-1T
IRS Reg. §1.469-5T
IRS Pub. 925 – Passive Activity and At-Risk Rules
IRS Pub. 946 – How to Depreciate Property
ICS Tax: How Cost Segregation Can Widen the STR Loophole
Trout CPA: STR Loophole Tax Savings
Tax Cuts and Jobs Act of 2017