Short-Term Rental Tax Strategies Under the One Big Beautiful Bill

The short-term rental (STR) market, fueled by platforms like Airbnb and VRBO, has become a lucrative investment opportunity for real estate investors. However, the tax implications of operating an STR are complex, with IRS rules creating a maze of classifications, deductions, and potential downsides. In this comprehensive guide, we’ll explore the tax treatment of short-term rentals and integrate the updated bonus depreciation percentages from the One Big Beautiful Bill (OBBA), passed in July 2025, to provide an effective strategy for maximizing tax savings. Whether you’re a seasoned investor or new to the STR game, understanding these rules can significantly impact your bottom line. 

Understanding Short-Term Rental Classifications 

The IRS categorizes short-term rentals into four distinct types based on two key factors: whether the rental is treated as a business or a passive activity, and whether the owner materially participates in its operations. These classifications are: 

• Business Short-Term Rentals with Material Participation 

• Business Short-Term Rentals without Material Participation 

• Passive Short-Term Rentals with Material Participation 

• Passive Short-Term Rentals without Material Participation 

These distinctions hinge on three critical factors: 

• Substantial Services: Are you providing hotel-like services to guests? 

• Material Participation: How involved are you in managing the property? 

• Tax Reporting: Does the rental income go on Schedule C (business) or Schedule E (passive rental)? 

Let’s break down each factor and explore how they shape your tax obligations, with a focus on leveraging deductions like bonus depreciation. 

Substantial Services: Business vs. Passive Rentals 

The IRS uses the concept of substantial services to determine whether an STR is a business (reported on Schedule C) or a passive rental (reported on Schedule E). Providing substantial services elevates your STR to a business, akin to operating a hotel, with significant tax consequences. 

What Are Substantial Services? 

Substantial services include: 

• Daily cleaning during a guest’s stay. 

• Daily changing of bed sheets or linens. 

• Concierge services. 

• Guest tours or outings. 

• Providing meals (e.g., daily breakfast). 

• Transportation services. 

• Other “hotel-like” amenities. 

If you provide these, your STR is classified as a business, and income is reported on Schedule C. This subjects net income to self-employment tax (15.3% FICA, though an S-Corporation can mitigate this). However, Schedule C reporting does not automatically allow ordinary loss deductions; material participation is still required (more on this below). 

Benefits of Avoiding Substantial Services 

If you don’t provide substantial services, your STR is reported on Schedule E, like a traditional long-term rental. This has two major advantages: 

• No Self-Employment Tax: Schedule E income is passive and exempt from FICA. 

• Ordinary Loss Potential: With material participation, losses can be deducted as ordinary losses against other income. 

You can still offer insubstantial services without losing Schedule E status, such as: 

• Utilities (heating, air conditioning, water, gas). 

• Internet and Wi-Fi. 

• Cleaning common areas. 

• Routine repairs and maintenance. 

• Trash collection. 

• Payment of HOA dues. 

Caution: The Gray Area 

The IRS provides limited guidance on what constitutes substantial services, with no clear court cases, Revenue Rulings, or Treasury Regulations to date. Avoid aggressive tactics (e.g., offering too many guest perks to boost rental rates) that might inadvertently trigger business classification, leading to higher taxes. Consult a CPA to ensure your services stay within Schedule E territory. 

Leveraging Material Participation for Ordinary Loss Treatment 

One of the most powerful tax strategies for STRs is converting passive rental losses into ordinary losses, which can offset other income (e.g., W-2 wages, business income) as an above-the-line deduction. Typically, this requires qualifying as a real estate professional (a high bar involving 750+ hours in real estate activities). However, an IRS loophole—stemming from Treasury Regulations predating the Airbnb era—allows STR owners to achieve this with material participation, even without real estate professional status. 

The Seven Tests for Material Participation 

To qualify, you must meet one of the following seven IRS tests for material participation (not all seven, just one). Tests 1, 2, and 3 are often the easiest for STR owners: 

• >500 Hours: You participate in the STR for more than 500 hours per year. 

• Substantially All Participation: Your participation constitutes nearly all the work on the property (including non-owners, like cleaners or managers). 

• >100 Hours, No One Else More: You participate for more than 100 hours, and no other individual (including non-owners) participates more. 

• Significant Participation Activity: The STR is a significant participation activity, and your total participation in all such activities exceeds 500 hours. 

• Five of Ten Prior Years: You materially participated in the STR for any five (consecutive or non-consecutive) of the prior ten years. 

• Three Prior Years (Personal Service): The STR is a personal service activity, and you materially participated for any three prior years. 

• Regular, Continuous, Substantial: Based on facts and circumstances, you participate regularly, continuously, and substantially. 

Why Material Participation Matters 

If you meet one of these tests, any net loss from your STR is treated as an ordinary loss, deductible against other income. This is a game-changer, especially when combined with strategies like cost segregation (discussed below), which accelerates depreciation to generate larger losses in the first year. 

Audit Risk 

This loophole relies on outdated regulations, and aggressive use (especially without real estate professional status) could trigger an IRS audit. Document your hours meticulously (e.g., logs of time spent on bookings, maintenance, guest communication) to substantiate material participation. Most CPAs advise caution, as the IRS may scrutinize these deductions. 

New Bonus Depreciation Rules for STRs Under the One Big Beautiful Bill 

The OBBA has updated bonus depreciation rules, providing a significant tax advantage for STR investors. Bonus depreciation allows you to deduct a large percentage of a qualifying asset’s cost in the year it’s placed in service, rather than depreciating it over several years. 

Updated Bonus Depreciation Percentages (2025) 

As of 2025, the OBBA has adjusted bonus depreciation rates for qualified property (including STR assets like carpet, appliances, and certain building components). The current schedule is: 

• 2024: 60% bonus depreciation. 

• Jan 1 – Jan 19 2025: 40% bonus depreciation. 

• Jan 20, 2025 – Forever: 100% bonus depreciation is reinstated and made permanent. 

These percentages apply to new or used property with a recovery period of 20 years or less (e.g., 5-year property like furniture, fixtures, or equipment) placed in service during the tax year. For STRs, this includes: 

• Furniture (beds, couches, tables). 

• Appliances (refrigerators, microwaves). 

• Carpets, flooring, and other interior improvements. 

• Certain building components identified via cost segregation (e.g., lighting, HVAC systems). 

Cost Segregation and Bonus Depreciation 

To maximize bonus depreciation, STR investors should consider a cost segregation study, which reclassifies portions of a property’s costs into shorter depreciation periods (5 or 15 years) rather than the standard 27.5 years for residential rentals. For example: 

• A $500,000 STR property might have $100,000 in 5-year property (carpet, appliances) and $50,000 in 15-year property (land improvements). 

• In 2025, if the property in-service date is after January 19th, you can deduct 100% of $150,000 in the first year via bonus depreciation. 

When paired with material participation, these losses become ordinary losses, offsetting other income and reducing your tax liability significantly. 

OBBA and STRs: Strategic Considerations 

• Timing: 2025 assets purchased in January should be placed in service on or after the 20th to receive 100% bonus treatment. 

• Audit Risk: Large deductions from cost segregation and bonus depreciation may attract IRS scrutiny, especially if paired with the material participation loophole. Ensure proper documentation and professional guidance. 

Personal Use of the Property: Don’t Lose Your Deductions 

The IRS allows you to treat an STR as a rental property even if you use it personally, as long as personal use is limited to: 

• ≤14 days per year, or 

• ≤10% of the total days rented to third parties. 

Fix-up days—staying at the property for work (e.g., repairs, maintenance, or management tasks)—do not count as personal use if documented properly. These days also unlock deductions for: 

• Travel (e.g., mileage or flights). 

• Dining (50% deductible if business-related). 

• Auto expenses. 

• Tools and supplies used for property work. 

Strategy: Avoid Personal Use 

To maximize deductions, treat all stays as work-related. Keep detailed logs of tasks performed (e.g., cleaning, repairs, guest check-ins) to substantiate fix-up days. This ensures the property retains its rental status and supports material participation claims. 

The Short-Term Rental Taxation Matrix 

To simplify the interplay of substantial services and material participation, consider the following matrix: 

Key Takeaways 

• Schedule E is preferable for avoiding self-employment tax and maintaining simplicity. 

• Material participation unlocks ordinary loss treatment, especially when paired with cost segregation and bonus depreciation. 

• Substantial services increase tax complexity and liability, so limit guest perks to insubstantial services. 

Practical Strategies for STR Investors 

• Optimize Reporting with Schedule E: 

• Avoid substantial services to keep income on Schedule E, minimizing self-employment tax. 

• Offer insubstantial services (e.g., Wi-Fi, utilities) to enhance guest experience without tax consequences. 

• Leverage Material Participation: 

• Aim for Tests 1, 2, or 3 (e.g., >100 hours with no one else participating more). 

• Document hours spent on bookings, guest communication, cleaning, and maintenance to support your claim. 

• Maximize Depreciation: 

• Conduct a cost segregation study to identify 5-, 7-, or 15-year property. 

• Apply 100% bonus depreciation in 2025 for qualifying assets, generating significant first-year deductions. 

• Pair with material participation to deduct losses against other income. 

• Use an S-Corporation (if Schedule C): 

• For business STRs, an S-Corp can reduce self-employment tax by separating salary from distributions. 

• Consult a tax professional to weigh setup and compliance costs. 

• Document Fix-Up Days: 

• Log all work-related stays to avoid personal use classification. 

• Deduct related expenses (travel, dining, tools) to lower taxable income. 

• Plan for Audits: 

• The material participation loophole and large depreciation deductions may attract IRS scrutiny. 

• Work with a CPA to ensure compliance and maintain thorough records. 

Conclusion 

Operating a short-term rental offers tremendous tax advantages, but navigating IRS rules requires careful planning. By avoiding substantial services, you can report income on Schedule E, sidestepping self-employment tax. Achieving material participation unlocks ordinary loss treatment, allowing you to offset other income with rental losses. The One Big Beautiful Bill enhances this strategy with 100% bonus depreciation starting after January 19th, 2025, supercharged by cost segregation to accelerate deductions. However, these benefits come with risks, including potential audits due to outdated regulations and aggressive deductions. 

To succeed, work with a tax professional to tailor your strategy, and ALWAYS document your activities meticulously. With the right approach, your short-term rental can be a powerful instrument for wealth-building and tax savings.  

Don't hesitate to reach out if you have questions about your short term rental or other investment properties. We are happy to discuss your specific situation. https://veritaxadvisors.com/contact-us