As an investor, diversifying your portfolio is crucial for long-term success. Short-term rentals (STRs), driven by platforms like Airbnb, Vrbo, and Booking.com, have become a standout option in the real estate market due to their high income potential and flexibility. But did you know that STRs can also be a smart way to lower your tax bill?

In this post, we’ll explore why STRs are an attractive investment option, how they can help reduce your tax liability, and key things you should know to maximize your return on investment. We’ll also discuss the material participation rule and its tax benefits, based on guidance from the IRS.

What Is a Short-Term Rental (STR)?

A short-term rental is typically a property or unit rented out for less than 30 days at a time. These rentals offer guests a unique and personalized alternative to hotels. STRs can range from a single room in a house to entire vacation homes, with rentals typically booked on a nightly or weekly basis.

For investors, short-term rentals offer significant income potential, especially when located in high-demand areas like tourist destinations, business hubs, or metropolitan cities. The flexibility of STRs—allowing you to rent a property on your terms and schedule—has made them increasingly popular among real estate investors looking for higher returns compared to traditional long-term rental properties.

The Investment Appeal of Short-Term Rentals

1. Higher Income Potential: STRs often generate higher rental income than traditional long-term leases, especially in desirable locations. As an investor, you can capitalize on peak seasons, events, or tourism trends to maximize your income by adjusting rates accordingly. In many cases, STRs can provide a much better return on investment (ROI) due to the flexibility of nightly rates versus a fixed long-term rent.
2. Diversification of Your Portfolio: Adding STRs to your investment strategy can help diversify your portfolio, as they tend to perform well even when long-term rental markets experience downturns. Because they are often driven by tourism, business travel, and local events, STRs can offer more resilience in volatile markets.
3. Flexibility: Unlike long-term rentals, where tenants are typically locked into leases, STRs offer flexibility to adjust pricing and availability as needed. As an investor, this flexibility allows you to better respond to market demands and optimize revenue.
4. Personal Use: Another key benefit of STRs is the ability to use the property for personal vacations or business trips when it’s not booked by guests. This flexibility is an attractive feature for investors who want to enjoy the property while also earning income.

How STRs Can Lower Your Tax Bill

As a real estate investor, one of the biggest advantages of short-term rentals is the potential for tax savings. Here are some ways STRs can help reduce your tax bill:

1. Deductible Business Expenses: Operating a short-term rental can offer various tax deductions. Expenses such as cleaning, maintenance, property management fees, and utilities are all deductible. You can also deduct any costs associated with improving or furnishing the property to make it more attractive to guests.
2. Depreciation: Depreciation is a powerful tax-saving tool for real estate investors. It allows you to deduct a portion of the property’s value over a period of time, typically 27.5 years for residential rental property. Even though land is not depreciable, the building and improvements can be depreciated annually to offset rental income, thereby reducing your overall tax burden.
3. Material Participation and the Tax Treatment of STRs: According to the IRS, a key factor in determining how your STR income is taxed is whether you materially participate in the rental activity. If you meet the material participation rules, your short-term rental activity can be treated as non-passive income, which means you can potentially deduct the losses from your STR against your ordinary income, including W-2 wages.
   To qualify as materially participating, you must be involved in the operation of your rental property on a regular, continuous, and substantial basis. IRS Publication 925 outlines the rules for material participation. If you meet any of the following seven tests, you are considered to materially participate:
   • You participated for more than 500 hours in the activity during the year.
   • Your participation was substantially all of the participation in the activity.
   • You participated for more than 100 hours, and no one else participated more than you.
   • You materially participated in the activity for at least 5 of the past 10 years.
   • You materially participated in the activity for any 3 years during the last 10 years.
   • The activity is a significant participation activity in which you participated more than 100 hours and the total participation is more than 500 hours.
   • You were involved in the activity for more than 100 hours and the activity is a personal service activity (such as providing personal services to tenants).
4. Meeting these criteria can help you avoid the passive activity loss (PAL) rules, which would otherwise limit your ability to deduct losses from the STR against your other types of income (e.g., W-2 income).

How to Get Started with Short-Term Rentals as an Investor

1. Choose a High-Demand Location: Select a property in an area with strong demand for short-term accommodations. Popular tourist destinations, business hubs, and areas near universities or large events are ideal. The location is one of the biggest factors influencing the profitability of an STR.
2. Understand Local Regulations: Before you invest, research the local laws regarding short-term rentals. Some cities have strict regulations that may require permits, licenses, or occupancy taxes. Failing to comply with these rules can result in fines or penalties.
3. Get Your Property Ready: Prepare your property by furnishing it and adding all necessary amenities that guests expect, such as high-speed internet, clean linens, and quality appliances. The more appealing and comfortable the space, the higher your chances of attracting positive reviews and repeat guests.
4. Track Your Expenses and Income: It’s essential to track all income and expenses related to your STR for tax purposes. Work with an accountant familiar with STR tax deductions to ensure you’re taking full advantage of the tax breaks available to you. Keep records of all expenses, including property management costs, repairs, and maintenance, which can be deducted from your taxable income.

5 Frequently Asked Questions About Short-Term Rentals for Investors

1. How does the material participation rule impact my taxes for an STR? If you materially participate in the STR activity, your income will be considered non-passive, which allows you to offset losses from the STR against your ordinary income (e.g., W-2 income). This can lead to significant tax savings. You must meet at least one of the seven material participation tests outlined in IRS Publication 925.
2. Can I deduct all my expenses related to a short-term rental? Yes, as long as they are ordinary and necessary for running the STR, you can typically deduct expenses like cleaning, maintenance, property management fees, and even a portion of your utilities and property taxes.
3. How can I maximize the depreciation deductions on my STR? Depreciation is a key tax strategy for STRs. You can depreciate the building (but not the land) over 27.5 years. Additionally, you can depreciate improvements made to the property, such as furniture and appliances. Make sure to consult a tax advisor to help you maximize depreciation and reduce your tax liability.
4. Do I need to collect taxes for my short-term rental? Yes, in many locations, you will need to collect occupancy taxes (similar to hotel taxes) from your guests. These taxes must be remitted to local authorities. Be sure to check local regulations to understand your obligations.
5. How much money can I make from a short-term rental? The income potential varies based on location, property size, and demand. In high-demand markets, STRs can generate significantly higher returns compared to traditional long-term rentals. As an investor, carefully analyzing the local market and competitive properties can help you maximize your income.

Conclusion

Short-term rentals are a smart investment that can offer higher returns than traditional long-term rentals, along with tax-saving benefits. By understanding how to leverage material participation rules and other tax strategies, investors can lower their tax bills while capitalizing on the growing demand for STRs. With the right property and strategy, STRs can be a profitable addition to your real estate portfolio.

If you’re considering adding STRs to your investment strategy, consulting with a tax professional and real estate advisor will help ensure you maximize both your returns and tax advantages.