Short-Term Rentals: Potential Tax Planning Opportunity for High-Income Earners

For high-income individuals and families, a large tax bill can naturally lead to questions about strategies that may help reduce current taxable income. Short-term rental real estate is one strategy that has received increasing attention because, under the right circumstances, it may offer tax treatment that differs from traditional rental property.

But the tax deduction is only part of the story.

A short-term rental is also an investment, an operating asset, a potential source of cash flow, and a commitment of both capital and time. For that reason, the strategy should be evaluated not only for its immediate tax benefits, but also for how it fits within the investor’s broader financial plan.

When certain requirements are met, including rules surrounding the average length of a guest’s stay and the owner’s level of participation, losses generated by a short-term rental may potentially be used to offset other nonpassive income. When combined with cost segregation and bonus depreciation, those losses can be substantial.

Understanding how the pieces fit together is important before deciding whether the strategy makes sense.

Why Short-Term Rentals Can Be Different

Traditional rental real estate is generally considered a passive activity for federal income tax purposes. As a result, losses from a rental property generally cannot be used to offset salary, wages, or other nonpassive income unless an exception applies.

Certain short-term rentals can be treated differently.

Under IRS rules, an activity generally is not treated as a rental activity for passive activity purposes when the average period of customer use is seven days or less.

That distinction can be especially important for an individual who does not qualify as a Real Estate Professional. Instead of automatically falling under the traditional passive rental rules, the activity may be evaluated under the broader material participation standards.

The length of the average guest stay, however, is only the first part of the analysis. The owner generally must also materially participate in the activity for resulting losses to be treated as nonpassive.

Material Participation: Ownership Alone Is Not Enough

Material participation focuses on how actively the taxpayer is involved in operating the property.

The IRS provides several tests for determining whether a taxpayer materially participates in an activity. Among those that may be relevant to a short-term rental owner are:

• Participating in the activity for more than 500 hours during the year.
• Performing substantially all of the participation in the activity.
• Participating for more than 100 hours during the year when no other individual participates more than the taxpayer.

Which test applies depends on the facts and circumstances.

This is where the operating model of the property becomes important. An owner who manages bookings, communicates with guests, coordinates repairs, works with vendors, handles bookkeeping, purchases supplies, and oversees day-to-day decisions may accumulate meaningful participation hours.

By contrast, an owner who turns nearly every responsibility over to a third-party property manager may have a more difficult time satisfying certain material participation tests.

That creates an important planning tradeoff. A highly involved owner may be better positioned to meet the applicable tax requirements, but that involvement also requires time and attention. Someone considering the strategy should therefore think realistically about whether operating a short-term rental fits with work, family, travel, and other commitments.

Documentation matters as well. Maintaining detailed, contemporaneous records of the time spent operating and managing the property can help support material participation if the taxpayer’s return is later examined.

Accelerating Depreciation Through Cost Segregation

Once a short-term rental qualifies for the appropriate tax treatment, depreciation can become an important part of the strategy.

Residential rental buildings are generally depreciated over a long period. But not every part of a property necessarily has the same recovery period as the building itself.

A cost segregation study analyzes the property and identifies components that may qualify for shorter recovery periods. Depending on the property, these may include certain furnishings, appliances, flooring, electrical components, landscaping, and other improvements.

Rather than depreciating those qualifying components along with the building over decades, some may be depreciated over much shorter periods.

It is important to understand what cost segregation does and does not accomplish. It generally does not create a new deduction. Instead, it changes the timing of deductions by accelerating depreciation that might otherwise have been spread over future years.

That timing difference can be valuable, particularly in a year when taxable income is unusually high. But it also means fewer depreciation deductions may be available in later years, which is one reason the strategy should be considered over a multi-year planning horizon.

Bonus Depreciation Can Increase the First-Year Impact

Current federal law provides a 100% additional first-year depreciation deduction for certain qualifying property acquired and placed in service after January 19, 2025. Eligible property generally includes certain depreciable assets with recovery periods of 20 years or less.

This is where cost segregation and bonus depreciation can work together.

A cost segregation study may identify portions of a short-term rental that qualify as shorter-lived property. If those assets also satisfy the requirements for bonus depreciation, their qualifying basis may potentially be deducted in the year the property is placed in service rather than depreciated gradually over several years.

For an investor purchasing a substantial property, the resulting first-year deduction can be significant.

The value of that deduction, however, depends on the investor’s broader tax situation. A large deduction may be especially useful in a year with high compensation, a bonus, equity compensation, a business transaction, or another source of taxable income. The same deduction may have a different planning value in a lower-income year.

An Illustrative Example

Consider an executive earning $2 million in W-2 income who purchases a $2 million property to operate as a short-term rental.

For purposes of illustration, assume:

• Purchase price: $2,000,000
• Amount allocated to land: $400,000
• Depreciable basis: $1,600,000

Now assume a cost segregation study determines that 30% of the depreciable basis, or approximately $480,000, can be classified as qualifying shorter-life property.

If those assets are eligible for 100% bonus depreciation, a substantial portion of that $480,000 could potentially be deducted in the first year. The taxpayer may also be entitled to depreciation on the remaining qualifying property.

Taken together, first-year depreciation deductions in this fictional example could exceed $500,000.

If the property satisfies the applicable short-term rental rules and the taxpayer materially participates, the resulting tax loss may potentially be treated as nonpassive and therefore may be available to offset other nonpassive income, including wages.

For someone in a high federal income tax bracket, that could produce a meaningful reduction in current-year taxable income.

The actual outcome would depend on the taxpayer’s circumstances, the cost segregation analysis, purchase-price allocation, basis, income, other deductions, applicable limitations, and federal and state tax rules.

Just as important, the tax deduction should be weighed against the amount of capital invested, the property’s expected cash flow, financing costs, and the investor’s overall financial position.

Start With the Property, Not the Tax Benefit

A large first-year deduction can make a short-term rental look attractive on paper. But the investment should still make sense without relying solely on the tax benefit.

An investor may want to evaluate expected rental income, occupancy rates, financing costs, insurance, repairs, maintenance, property taxes, management expenses, and the potential for periods when the property is vacant.

Local regulations matter as well. Municipalities, condominium associations, and homeowners associations may restrict or regulate short-term rentals. Rules can change, and a property that works well under one set of local regulations may become less attractive if those rules change.

Liquidity should also be considered. Real estate is generally less liquid than a traditional investment portfolio, and purchasing a short-term rental may require significant cash for a down payment, improvements, furnishings, reserves, or unexpected expenses.

For someone who already owns a primary residence, vacation property, commercial real estate, or a business tied to real estate, adding another property may also increase concentration in a single asset class.

The tax benefit may improve the economics of the investment, but it should support a sound investment decision rather than substitute for one.

Think Beyond the First-Year Deduction

Accelerating depreciation into the first year can provide a meaningful current tax benefit, but there are longer-term consequences to consider.

Taking larger depreciation deductions today generally reduces the property’s tax basis. That can affect the tax consequences when the property is eventually sold, and some depreciation may be subject to recapture.

An investor should therefore evaluate the current deduction alongside the expected holding period, potential appreciation, future tax rates, and likely exit strategy.

Participation can change over time as well. An owner may initially manage the property personally and later decide to hire a property manager or reduce involvement. A change in participation could affect the tax treatment of the activity in future years.

This is another reason to view the strategy as a multi-year planning decision rather than a one-time tax transaction.

How a Short-Term Rental Fits Into the Broader Financial Plan

A short-term rental touches more areas of a financial plan than taxes alone.

From a cash-flow perspective, the owner needs sufficient liquidity not only to purchase the property but also to handle debt service, taxes, insurance, maintenance, vacancies, furnishings, and unexpected repairs. Capital committed to the property is also capital that is no longer available for other goals.

From an investment perspective, the property should be considered alongside the rest of the portfolio. The question is not simply whether the property may appreciate, but whether adding more real estate supports the household’s desired level of diversification, liquidity, and risk.

Tax planning should be coordinated as well. The timing of depreciation deductions may interact with compensation, equity awards, business income, charitable giving, Roth conversions, or other strategies being considered in the same year.

Estate planning may also come into play. How the property is titled, whether it is owned individually or through an entity, and how it may eventually transfer to heirs can have legal, tax, and administrative implications.

For business owners and executives, there may also be a practical question of time. A strategy that requires meaningful personal participation should be evaluated realistically alongside professional and family responsibilities.

Viewed this way, the short-term rental is not simply a tax strategy. It is an investment decision that can affect taxes, cash flow, portfolio construction, liquidity, estate planning, and long-term financial goals.

Bringing the Pieces Together

Short-term rental real estate can create an interesting intersection between investment planning and tax planning.

When the applicable rules are satisfied, an owner who materially participates in a qualifying short-term rental may be able to treat losses differently than losses generated by traditional rental real estate. Cost segregation may accelerate depreciation deductions, while bonus depreciation may further increase the amount deductible in the year qualifying property is placed in service.

Those benefits can be meaningful, particularly for a taxpayer experiencing a high-income year.

But the strongest planning case is generally not built around the deduction alone. It depends on finding a property with sound economics, maintaining the appropriate level of participation, preserving sufficient liquidity, understanding the long-term tax consequences, and making sure the investment fits within the broader financial plan.

Before implementing a short-term rental strategy, investors should consider coordinating with their wealth advisor, tax professional, and other appropriate professionals to evaluate how the opportunity fits with their investment, tax, cash flow, estate planning, and long-term financial objectives.

If you would like more information about the terms and strategies discussed in this guide, or if you’re ready to explore how they apply to your specific situation, contact Waverly Advisors. With experience working with individuals, families, and executives managing significant wealth, we specialize in creating tailored strategies with the goal to help you grow, protect, and transfer your assets effectively.