7 ways to qualify for short-term rental material participation!

If you have a rental property, chances are you've heard of the short term rental loophole, but what does that really mean and do you qualify?

Did you know not all rentals are created equal? i.e. just because you have a short term rental doesn't mean you can deduct all costs and therefore lower your tax bill. The first key thing to understand is passive versus active.

Passive - All rentals default to passively derived income. Other examples of passive income are interest income, dividend income, and other types of investment income. Think of passive income as income derived from little to no effort.

Active - The most common types of active income are self employment and W2 income. Think of active income as income you actively have to work at to obtain. Active income involves some type of performance obligation(s).

Where short term rentals fall into that : short term rentals fall under passive unless you meet 1 of 2 thresholds : (1) your modified adjusted gross income is under a certain limit (around $150k max) or (2) you actively participate (7 possible routes to meet this bar).

If your rental is rented to a single tenant or long term renter, it is unlikely you will be able to qualify for material participation. If you don't believe you fall under active participation and instead fall under passive participation, that just means :

• You can still report and record your rental income and expenses

• You just can't take a loss for any losses that exceed income in that given year

• The overflow losses carry forward and either offset future taxable rental income or they carry until you sell the property and later offset any capital gains

Threshold 1 (up to $25,000 Loss):

1. You must actively participate (You must be involved in management decisions in a "significant and bona fide sense," such as approving new tenants, setting rental terms, and approving maintenance and repair expenses. This is a less stringent standard than "material participation" and can be met even if you use a property manager.)

2. You must own more than 10% of the property

3. If your income is under $100k, you get the full $25k. If your income is over $150k, you get $0. It is phased out in between $100k-$150k.

Threshold 2 (Material Participation):

1. REQUIRED: Average period of customer use is 7 days or less

2. REQUIRED: Average period of customer use is 30 days or less AND significant personal services are provided

3. You must meet 1 of the 7 material participation tests (See below)

IRS Reference : 26 CFR § 1.469-5T - Material participation.

Read here for specific detailed brief by Cornell Law.

7 Material Participation Tests to qualify as an active short term rental (must meet 1 to qualify)

Taxpayer meets material participation if any ONE of the following is true:

1. Test 1 — 500 Hours

   1. Taxpayer participated > 500 hours in the activity.

2. Test 2 — Substantially All Participation

   1. Taxpayer did substantially all (essentially 100%) of the work.

   2. This will not be possible to be met if you have a property manager

3. Test 3 — 100 Hours + More Than Anyone Else

   1. Taxpayer participated ≥ 100 hours, AND

   2. No other individual (including contractors, cleaners, co-hosts, Airbnb management, spouse unless MFJ) participated more.

   3. This will not be possible to be met if you have a property manager

4. Test 4 — Significant Participation Activity (SPA) > 500 Hours

   1. Taxpayer has multiple SPAs (each >100 hours) totaling > 500 hours across all SPAs.

   2. This is the easiest to meet if you have multiple rentals

5. Test 5 — 5 of the Last 10 Years

   1. Taxpayer materially participated in this activity for 5 of the last 10 years.

6. Test 6 — Personal Service Activity (3 Years)

   1. Applies mainly to health, law, engineering, accounting, architecture. (Rarely used for STRs.)

7. Test 7 — Facts & Circumstances (Regular, Continuous & Substantial)

   1. Must be ≥ 100 hours AND taxpayer is crucial to operations.

   2. Note: IRS often scrutinizes this — use cautiously.

So WHAT hours and activities count towards 'material participation' and what hours and activities don't? This is key to making sure your short term rental is not taxed as a passive activity.

Hours that DO Count!

• Guest messaging and managing bookings

• Cleaning between guest stays

• Supply runs (bed sheets, consumables, toiletries)

• Repairs, maintenance, coordination

• Bookkeeping, listing management, pricing updates

• Marketing the property

• Travel to property only if work is done on-site

• Meeting service providers (cleaners, contractors, inspectors)

• In-person oversight or supervisory work

• Again, it's key to note that it will be highly unlikely you'd qualify for active participation if you have a property manager as they normally perform all of the above tasks

Hours that Do Not Count

• Investor-level activities (planning, strategizing, financial projections)

• Time reviewing reports without making operational changes

• Pure research (scrolling Airbnb/VRBO/YouTube)

• Travel with no work substance

• Work done by paid cleaners, contractors, Airbnb management

• Time spent by spouse (if MFJ spouse time does count)

So you have a short term rental, you meet 1 of the 7 tests and you've counted all of your hours. But how do you need to document the hours to pass any short term material participation audits from the IRS?

Time Log!!

• i.e. you can use Google Sheets or a simple Excel log.

• Each entry should include:

  • Date

  • Hours spent

  • Description of activity

  • Impact on operations (optional but excellent for audit support)

  • Which property you were working on (if you have multiple)

• Supporting records

  • Invoices & receipts

  • Contracts with cleaners/contractors

  • Airbnb/VRBO activity logs

  • Messaging screenshots (if needed)

  • Maintenance logs

  • Mileage logs (if repairs or supplies)

• Segregate owner-use days

  • Owner stays must be logged and removed from participation hour days.

  • Please note that if you're audited on the short term material participation stance you take on your tax return, the taxpayer bears the burden of evidence and proof so you alone have to substantiate the tax position of claiming rental activity(s) are active versus passive. Should the IRS find your evidence insufficient, that may result in increased tax, interest, and penalties so it's pivotal that you document accordingly.

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