The Short-Term Rental Loophole: Material Participation and Bonus Depreciation

A seven-day average stay takes the property out of the rental rules

Section 469(c)(2) makes every rental activity passive, whatever your involvement, unless you qualify as a real estate professional. The passive activity loss rules for landlords explain the default. Reg. section 1.469-1T(e)(3)(ii) then lists activities that are not rental activities at all, starting with property whose average period of customer use is seven days or less.

Publication 925 gives the arithmetic: divide the total number of days in all rental periods by the number of rentals during the year. A second exception covers an average of 30 days or less when you provide significant personal services, judged by frequency, labor and value; cleaning common areas and routine repairs typical of long-term rentals do not count.

Passing the test does not make losses deductible by itself. It moves the activity out of section 469(c)(2) and into the general rule for trades or businesses, under which an activity is passive unless you materially participate.

Material participation is the second gate, and the hours must be documented

Reg. section 1.469-5T(a) lists seven tests. The ones short-term rental owners usually rely on are more than 500 hours in the year; participation that is substantially all of the participation of all individuals, including non-owners; and more than 100 hours that is not less than any other individual's participation. Cleaners, managers and co-hosts count as other individuals, so a busy cleaning crew can defeat the 100-hour test.

Section 469(h)(5) says your spouse's participation is taken into account in deciding whether you materially participate. Reg. section 1.469-5T(f)(4) says participation may be established by any reasonable means, such as calendars and summaries, and contemporaneous logs are not required, though they are the strongest evidence.

If you meet the seven-day test but not material participation, the activity is a passive business, its losses wait for passive income, and the $25,000 allowance does not help because it applies to rental real estate activities. The real estate professional tests are a separate route for long-term rentals.

Bonus depreciation creates the large first-year loss

Publication 946 says qualified property acquired and placed in service after January 19, 2025 takes a 100 percent special depreciation allowance unless you elect out. It covers tangible MACRS property with a recovery period of 20 years or less, so a cost segregation study that separates furnishings, appliances, carpeting and site improvements from the building lets you expense those parts immediately. Publication 527 lists appliances, carpeting and furniture used in residential rental property as 5-year property.

The building itself is not eligible. Section 168(e)(2)(A) excludes from a dwelling unit a unit in a hotel, motel or other establishment more than half of whose units are used on a transient basis, which affects whether a short-term rental building uses the 27.5-year or 39-year period; settle that with your CPA.

Two 2026 limits apply. Under section 461(l), business losses above $256,000, or $512,000 on a joint return per Rev. Proc. 2025-32, are disallowed and carried forward as a net operating loss. Publication 527 also limits deductions if your personal use exceeds the greater of 14 days or 10 percent of the days rented at a fair price.

A worked example: a $1,000,000 short-term rental bought in 2026

Hypothetical, round numbers. A couple with $600,000 of joint taxable income buys a beach house in 2026 for $1,000,000. A cost segregation study assigns $150,000 to furnishings, appliances and site improvements, which they expense with bonus depreciation, and with building depreciation and operating results the rental shows a $150,000 tax loss for the year.

Guests stay an average of four nights, and one spouse logs more than 500 hours managing bookings, turnovers and maintenance. The loss is nonpassive and under the $512,000 limit, so taxable income drops to $450,000. Using the 2026 joint brackets in Rev. Proc. 2025-32, 35 percent above $512,450 and 32 percent above $403,550, the federal saving is about $50,600.

Run your own numbers with your CPA. If the average stay drifts above seven days, or the cleaning company outworks you, the same loss is passive and the saving disappears for that year.

The sale gives much of the deduction back, and an exchange defers only part

On a sale, section 1245 treats gain on the expensed furnishings and equipment as ordinary income up to the depreciation taken. Site improvements that took bonus are section 1250 property, and bonus counts as depreciation above straight line, so the gain on them is also ordinary up to that excess, as the land improvements page explains. Straight-line building depreciation is unrecaptured section 1250 gain taxed at up to 25 percent.

A 1031 exchange defers gain on the real property, but since 2018 section 1031 covers only real property. Section 1245(b)(4) limits deferred recapture to cases where you acquire section 1245 property, so recapture on the furnishings is generally recognized even in an exchange. The short-term rental 1031 page and the exit from short-term rentals guide cover replacement choices, including passive Delaware statutory trust interests.