Tax Pitfalls and Loopholes of Airbnb and Short-Term Rentals

September, 16 2025 by Lisa Brugman, EA

A Guide to Short-Term Rental Tax Rules, Loopholes, and Depreciation

Renting out a property on websites like Airbnb or VRBO can help you make good money. But when it comes to taxes, things can get a little tricky. There are special rental rules that can impact how the net income is taxed. For example, the net income may be subject to income and self-employment (Social Security and Medicare) taxes. Or the net income may be subject to only income tax. Likewise, net losses are treated differently depending on whether the activity is considered a trade or business or a passive activity. Most rentals are considered passive activities, which means you may not be able to deduct all of your losses in the year they occurred. Unless there is an exception, passive losses can only offset net passive income. For purposes of the passive activity rules, passive income does not include items such as interest, dividends, and other portfolio income. Other passive income does include the net active income from a closely held C corporation, but not if the closely held C corporation is a personal service corporation. (This area of tax gets complicated, so we suggest contacting a local tax professional for more information on the types of passive income that can offset a loss from a passive activity.) So, if you have no passive income to offset the losses, the losses are suspended and carried over, which can cause you to have a higher tax liability. The losses from some rental activities, such as short-term rentals, may not be limited to passive net income if certain conditions are met. One of these exceptions applies to short-term rental activities. The short-term rental rules are narrow, so many conventional rental properties will not qualify. But if your rental is considered a short-term rental property, understanding these rules can be beneficial. To avoid problems with the IRS and pay the right amount of taxes, you have to understand the rules and plan things out the right way.  

This guide breaks down the most critical tax concepts every short-term rental owner needs to understand, including potential loopholes and IRS red flags, to help you avoid common pitfalls.

 

What Is a Short-Term Rental?

A short-term rental is generally a property you rent out for short stays, usually 7 days or less, or 30 days or less*, with substantial (i.e., significant) personal services provided to the guests. Think about homes or apartments rented on platforms like Airbnb or VRBO. 

*Keep in mind that the “7 days or less” and the “30 days or less” rules are two distinct rules. If you have questions about the differences in these rules, we recommend reaching out to a local tax professional to discuss them in more detail. Additionally, IRS Publication 925, Passive Activity and At-Risk Rules, includes a discussion of these rules starting on page 4 under “Rental Activities.”

 

The Short-Term Rental Loophole

One of the most talked-about tax opportunities for Airbnb and VRBO hosts is the short-term rental (STR) loophole, which allows certain rental activities to be classified as active (nonpassive) rather than passive. We will be discussing what is meant by “classified as nonpassive rather than passive” in a moment.
 

Requirements for the STR Loophole

To use this loophole, your short-term rental activity must meet two primary conditions:
 

1. Average Stay Length: The average customer stay must be 7 days or less, or 30 days or less, with substantial (i.e., significant) personal services provided to the guests.  
    
2. Material Participation: You must materially participate in the management and operations, according to the IRS. The material participation test is mentioned below. 

Meeting these qualifications can let you offset short-term rental losses against active income. Examples of active income include wages, tips, commissions, salaries, and self-employment income where the taxpayer materially participated in the business activity, etc. This can potentially create huge tax savings, especially in the early years when depreciation and startup costs are high. Most rental real estate properties are considered passive activities by nature, meeting the above requirements can make the income non-passive, thus avoiding self-employment tax (i.e., Social Security and Medicare tax for sole proprietorships).

 

Understanding Passive Activity Rules as They Relate to Rentals

The IRS distinguishes between passive and non-passive income to determine which types of income and losses can offset each other. Generally, rental income is considered passive, meaning it can only offset other passive income or gains. But there are exceptions, especially for short-term rentals.

 

What Makes an Activity Passive or Non-Passive?

You must meet one of the IRS’s material participation tests to reclassify your short-term rental activity as non-passive. These tests assess how much time and effort you put into managing the property. Some key thresholds include:
 

• You participate in the activity for more than 500 hours during the year. 
• Your participation is substantially all of the participation for the activity. 
• You participate more than 100 hours, and no one else participates more than you. 

If you meet any one of these requirements with your STR, your activity may be classified as non-passive, which can allow rental losses to offset other active income, such as W-2 wages or business income.

 

Defining “Substantial Services” and Why It Matters

One of the ways the IRS will determine if your STR qualifies as passive vs. non-passive is whether you provide “substantial” (i.e., significant) personal services. The term “substantial services” refers to additional offerings that go well beyond the basics of property rental. Understanding this distinction is crucial for proper tax treatment as it will determine whether your income is subject to self-employment tax or treated as traditional rental income. 

Examples of substantial services include:
 

• Daily cleaning during a guest’s stay 
• Changing linen 
• Breakfast or other meals or grocery delivery 
• Transportation services 
• Concierge, tour planning, or guest entertainment 
• Personal laundry services 
• Other hotel-like services 
• On-site staff 

Why It Matters

If you provide substantial services, your income is no longer passive, and your rental investment becomes a rental business. This means you’ll owe both income tax and self-employment tax on any net profit shown. The amount of income tax will vary depending on your other income, but the self-employment tax rate is generally 15.3% of any net profit you receive. Self-employment tax equals the Social Security and Medicare taxes that are divided between and paid by both the employee and employer.  When a person is self-employed, they are considered both the “employer” and “employee” for Social Security and Medicare tax purposes. When a rental activity rises to the level of an active trade or business, any net income will be subject to income tax and self-employment tax.
 

What Doesn’t Count?

Basic services or amenities that are customary and minimal for a short-term rental do not qualify as substantial services. These are actions of real property operations:
 

• Cleaning between guest stays, trash collection 
• Providing linens, toiletries, or kitchen basics 
• Routine maintenance, snow removal, landscaping 
• Restocking supplies 
• Providing security 

If you stick to non-substantial or incidental personal services as listed above, but still materially participate in the STR rental activity (see “What Makes an Activity Passive or Non-Passive?” above), your income will generally be reported on Schedule E, Supplemental Income and Loss, instead of Schedule C, Profit or Loss From Business (Sole Proprietorships), and avoid self-employment tax.

 

Implementing the STR Loophole

This is where the STR loophole comes into play. If you have a rental property where the average customer stay is 7 days or less, or 30 days or less, and substantial (significant) personal services were provided to the guests, the activity is not reported on Schedule C, Profit or Loss From Business (Sole Proprietorships), and the net income is not subject to self-employment tax. The rental activity would be reported on Schedule E, Supplemental Income or Loss. Additionally, the activity would be classified as non-passive, which would allow any losses to be offset by other active income, such as wages. Keep in mind that this loophole only qualifies if all the rules and conditions are met.  

Pro Tip: Keep detailed logs of your time spent managing the property. 

Your material participation log should include:
 

• Date of participation. 
• Time spent on participation, including start and ending times. 
  • Note here that your travel time getting to and from the property doesn’t count. However, we do recommend you track your mileage to claim associated auto expenses. 
• Activity categories like tenant management, maintenance and repairs, marketing and advertising, bookkeeping and administration, property visits, contractor supervision, communications, and operations management. 
  • Investor-type activities do not count, such as financial review, long-term planning, passive oversight, or portfolio monitoring. 
• Detailed description of the activity. 
• Location of the activity, address of the property where the activity takes place (if you have more than one rental). 
• Notes and supportive documentation, such as invoices, receipts, emails, 

Depreciation of a Dedicated Airbnb/VRBO Unit

Depreciation is one of the most powerful deductions available to real estate investors. It allows you to recover the cost of your rental property over time by reducing your taxable income, even if the property's value is appreciating. 

Most short-term rentals are classified as residential rental property, meaning they are depreciated over 27.5 years. This includes the building structure but not the land. For example, if you purchase a property for $300,000 and the land is valued at $60,000, you can depreciate $240,000 over 27.5 years - about $8,727 per year. 

Be careful, though—if you are providing substantial services and your activity becomes a business, the IRS may determine that your rentals are actually commercial properties, which are depreciated over 39 years, significantly decreasing your tax write-off for depreciation.
 

Common Tax Pitfalls for Short-Term Rental Hosts

Many short-term rental owners miss opportunities or fall into traps due to a misunderstanding of the IRS rules. Here are some pitfalls to watch out for:
 

1. Misclassifying Rental Activity

Improperly labeling your passive rental income as active without meeting the IRS tests can backfire, especially if you’re audited. Make sure your rental duration and participation match the classification you choose. Understand the rules thoroughly; whether you qualify for a particular treatment can vary from year to year. While you may qualify as an active rental in one year, it may become a passive rental if your activity decreases the following year. Remember, the default classification for a rental is passive; it’s up to you to prove that it is an active rental.
 

2. Skipping Depreciation

When you buy a rental property, you slowly "write off" (claim a deduction) on part of the building’s cost each year through a process called depreciation. Depreciation reduces your cost basis, which is generally the amount you paid for the property, plus any major improvements and minus the value of the land. So, when you sell your rental property for a profit, your gain is bigger because your cost basis is lower. Here is an example.

Example: Buy $250,000 property with a land value of $50,000 (not depreciable)
 

• You bought the building for $200,000 
• You took $43,636 in depreciation on the building 
• Your new cost basis is now $156,364 ($200,000 - $43,636) for the building. 

Calculating the net gain or loss on the sale. (You will need to add back the land value when calculating the net gain or loss.) We recommend using the instructions on IRS Form 4562, Depreciation and Amortization, to calculate this information. You can also contact your local tax professional for additional assistance.
 

• You sold the property for $500,000. 
• Your adjusted basis (building + land) is $206,364 ($156,364 + $50,000) 
• Your total gain is: $500,000 − $206,364 = $293,636   

According to the rules, depreciation is allowed or allowable. “Allowed” depreciation represents the depreciation deduction claimed on the taxpayer’s return, whereas “allowable” depreciation is the depreciation a taxpayer could have deducted but did not. Consequently, even if you don’t claim a depreciation deduction on your rental building, you will still be required to recapture the depreciation as if the deduction was taken, thus increasing your tax burden.
 

3. Overlooking Occupancy Taxes and Business Licenses

Many states and localities require short-term occupancy taxes, similar to hotel taxes. Airbnb and VRBO may collect and remit these for you, but not in all jurisdictions. You’re still responsible for filing or remitting them where needed. If your activity is considered a business, you may also need to obtain a business license from the local jurisdiction if they require one.
 

4. Failing to Track Personal Use

If you use the property yourself, even occasionally, you must track the number of days you use it for personal purposes versus rental use. This is especially critical if your Airbnb property is in a resort area where it is likely to be used for personal use, such as a beach property or lake cabin. Personal use can impact how much you can deduct and whether you can even deduct losses at all. If your personal use of the property exceeds 14 days during the tax year, it falls under different rules for vacation homes, and no losses are permitted.
 

5. Weak Documentation

Keep meticulous records, logs, and receipts if you’re claiming material participation. The IRS requires documentation to prove your position, especially when you’re taking large losses or accelerated deductions.

 

Additional Considerations

Home Office Deductions

Normally, you do not get a home office deduction for your rental investment property activity. But if you qualify for the STR Loophole, you may qualify for a home office deduction, even if you claim your rentals on Schedule E, Supplemental Income and Loss. If you manage your rental business from a home office, and you meet the material participation rule, whether or not it is on a Schedule C, or on the Schedule E due to the STR loophole, just ensure the space is used exclusively and regularly for your rental activity. That means it must only be used as an office – your guest room won’t qualify, even if you have a desk in it that you use for your activity. Using the office even occasionally for non-business uses (such as the occasional overnight guest) disqualifies the home office from a deduction.
 

Insurance Considerations

Your regular homeowner’s insurance likely won’t cover short-term rentals. Make sure you have proper commercial or short-term rental insurance coverage, which may also be deductible as a business expense.

 

Final Thoughts

Owning a short-term rental and marketing it through platforms like Airbnb or VRBO can be a fantastic way to build wealth, but only if you understand the rules that come with it. From navigating the day-to-day services to your renters to properly depreciating your property and correctly classifying your income, there are plenty of opportunities to reduce your tax burden and just as many ways to make costly mistakes. 

Working with a knowledgeable tax professional or Enrolled Agent who understands the intricacies of short-term rental taxation can maximize your deductions and minimize your risks. The right advice can save you thousands and ensure you stay compliant while maximizing deductions.