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Tax Smart Real Estate Investors Podcast
360. Why Short-Term Rentals Are Still the #1 Tax Strategy for 2026 ( + New Tax Court Case)
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In this episode of the Tax Smart REI Podcast, Tho…
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You're now listening to the Tax Smart REI Podcast, the number one tax podcast for real estate investors.
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Your source for all things real estate, accounting and tax. Here we reveal our secrets that can save you thousands in taxes, streamline your accounting process, and help grow your business. Stay tuned to hear insightful interviews with industry experts, successful real estate investors, and current clients on what strategies they use to grow their business and how they steer clear of Uncle Sam.
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Hi everyone. Thanks for tuning in to this week's episode of the Tax Smart REI Podcast. Today we'll be talking about the number one tax strategy for 2026. And with Nate out of the office today, I'm going to be doing this episode solo. It's the first time I've done a solo episode in quite some time, so I'm excited to do it and we'll be diving into everything in just one minute. You've probably never found a real estate newsletter worth reading, and that's because we hadn't created ours yet. The REI Daily is a newsletter you actually want to read whether you own one property or a hundred. We created this for you if you each issue delivers crucial tax saving strategies, legislative updates, as well as real estate market insights, everything you need to stay sharp and ahead of the game. Get the real estate and tax news that actually matters straight to your inbox. Subscribe to the REI Daily newsletter today@therealestatecpa.com subscribe that's it for now and right back into today's episode. All right, and we are back. Thanks again for everybody tuning in. This is the first episode of the year and the number one tax strategy for 2026 is. Drumroll, please the short term rental looph the short term rental strategy, whatever you want to call it, it is investing in short term rentals and operating them a certain way so you can get significant tax Savings against your W2 or your active business. Income and tax savings often can range anywhere between five figures all the way up to six figures. We had one client save $130,000 with one short term rental. We had another client with one short term rental save over $300,000 in taxes over several years. We interviewed that client here on the podcast so you can go check those episodes out in the backlog if you do want to catch those. But what we'll be covering today is why is the short term rental strategy still the number one tax strategy in 2026? We're going to recap what the strategy is. We're going to talk about the legitimacy of the strategy because there's still a lot of people here, even as of late 2025, who are questioning whether or not the strategy legitimate. So we're going to put that to rest here on this episode. We're also gonna talk about a new tax court case that was recently released here in I believe it was December, late December 2025, regarding reps, the real estate professional status as well as short term rentals. And then we're talking about other strategies that are powerful. But I still believe the short term rental strategy will trump those strategies, no pun intended, or anything like that. So let's go ahead and get started. Why is this still the number one tax strategy in 2026? First things first, at the federal level. So the federal tax regulations, there's no indication whatsoever that they're looking to change these rules at the core of the short term rental strategy, which I'll be going to just a second. And then on top of that 100% bonus, depreciation was just made permanent in the one big beautiful bill that was passed in July 2025. So for the foreseeable future, short term rentals will be still the number one strategy. There's been no changes. And if there are ever any changes to this strategy, you will probably hear it here first. All right, so let's recap what the strategy is. So the strategy involves buying a rental property and renting it out for an average period of customer use of seven days or less. That makes it a business, not a rental property. Okay? That's the first key. Or 30 days or less if you provide substantial services, which are hotel like services to your guests while they stay at the property. Things like daily cleaning, daily meals, things of that nature. All right, that's the first rule. We have to take it from a rental property into a business. And we do that by meeting one of those two tests right there. The next thing we have to do, even though it's a business, we still have to materially participate in that property in order to take the losses as non passive and offset our W2 or our active business income. We materially participate by meeting one of the seven material participation tests. Again, there's seven of those, but there's three that typically make the most sense. The first one is you do substantially all of the work yourself, meaning you're a one person show you have little to no outside help. All right? The second one is you spend more than 100 hours on the property and no one other individual spends more time than you. And for the purposes of these tests, by the way, if you are married, the time you and your spouse spend on the property count as one person, right? So you're not separate, you're one person for the purposes of these tests. Now, this 100 hour test is the most popular one and we'll talk, I'm sure, more about that as we go through this episode. But the third one is you spend more than 500 hours on the property and at that point, doesn't matter how much time anybody else spends, if you spend 500 hours, you've met the test. Now that's how we do it. That is the strategy. Now, once you do those two things, you can now take the losses from your short term rental against your W2 income or your active business income. But how do you make this strategy even more powerful? Right. Well, you're going to do that by doing a cost segregation study on your property and have a cost segregation study performed. And the cost segregation study is going to break down the various components within your property into 5, 7 and 15 year class lives and the amount that's allocated within those class lives, those depreciable lives will be eligible for 100% bonus depreciation, which means you're able to fully deduct those in the first year you start operating your short term rental property. Okay. And that often leads to significant tax deductions. And that's because somewhere between 20 and 30% of the property is purchase price, buildings basis. The actual building itself, because land is not depreciated is often allocated over there and that's what creates substantial deductions. Okay, so that is the strategy in a nutshell. We're Talking about Airbnbs, VRBOs, short term rentals here. Now let's move on to the legitimacy of the strategy and then I'll talk about why it was considered a loophole. Okay, so a lot of people have still been questioning the legitimacy of the strategy. And at this point I think there's enough information out there, it's pretty ubiquitous, that this should be put the rest. But let's go ahead and knock this out. Okay, so the first thing that we need to take a look at is reg. Section 1.4691 TE3CAP A. And under that it says that if the activity is not a rental activity, meaning it's a business activity, if the average period of customer use of such property is seven days or less. Okay, again, that is Reg. Section 1.4691 TE3II Cap A. Now, it doesn't just end there. You can also find this in IRS publication 925 passive activity and at risk rules. So you can find it there. Additionally, there's been several tax court cases that have basically legitimized this strategy, including one that took place in 2020, which is Lucero versus Commissioner TC Memo 2020 136. And long story short, this person had several of this taxpayer. They had several flaws in their execution of the short term rental strategy and what ultimately led them to lose the case. There are several reasons, but the main reason, in my opinion, if you look at the task force case, is that they were unable to prove the amount of time that their property manager spent on the property and thus the task court did not believe that their property manager spent less time than them and they lost the case on the material participation basis. Okay. Had they been able to make that proof, perhaps they would have won that case, which is why documenting your time is so important when you are using this strategy. But there are even more cases, so let's continue. Okay. One of the things that often comes up within this strategy is the average peer to customer use of seven days or less. Okay. That is key. Now it's 7.000 repeating or less. And let's dive into some of this. So there's another task court case, James v. Judith M. Patterson vs. Commissioner from 2002. This is going back a long time. Now with the task court, they brought out the decimal to 5.60000000. I'm just making sure, I'm counting the amount of zeros they brought it out to. It was several zeros, meaning that they calculated not as 5.6, but 5.600000. There's another task court case, Moreno vs USA where they determined that the average period of customer use was 1.25 5714. Okay. So they will carry it out multiple decimal points. So you want to make sure that if you have the average period of customer use that it is seven days or less. Okay. 7.01. 7.00001. It may, if they catch it, will cause you to fail the test. Okay. Additionally, there is another task court case. This is another one. Michael J. Rogerson vs. Commissioner TC Memo 2022 49, where the task court determined that without any periods of customer use, it's impossible to savage the average period of customer use. So it's not enough to merely buy a short term rental property, say it's a short term rental and be able to use this strategy. You need to actually have customers stay at your property to determine that the average period customer use is seven days or less. So why am I going through these tax strategies right now? Because it's documented very clearly in the regulations, in IRS publications and now multiple strategies that go to show you that this is a completely legitimate strategy. Moreover, we as a firm have defended many at this point, audits involving short term rentals. Okay, so we defended those audits, and this is clearly legitimate now. So before anybody gets scared, oh, I don't want to want to face an audit. First of all, audit rates are extremely low. They're about less than 1% across the board. Even at our firm, just with some rough calculations I ran, it's less than 2%. And we've been using sophisticated strategies like the real estate professional status and short term rentals for many years now. And the reason why the audits did crop up over the last few years was one of the acts, I believe it was the CARES act, if I'm not mistaken, didn't provide the IRS with additional funding to the tune. I think it was like $80 billion. I don't have the numbers pulled up in front of me, but they had received a lot of funding and they used it to pick up audits. And that's why some of those audits had came up over the last few years. But the IRS has since lost that funding and we've seen audits tick down as a result of that. So audit rates are extremely low. And if you do want to use this strategy, it's very simple. If an audit ever does, God forbid, knock on wood, come your way, you want to make sure that you've clearly documented your position. Okay? Clearly documented that you had an average period of customer use of seven days or less, and that you've clearly materially participated. Usually the best way to do that, Excel spreadsheet or time tracking tool. And then if you are using that a hundred hour test where you have to spend more than a hundred hours and no one other person is spending more time than you, then you need to document the amount of time that other people spent because again, in Lucero versus Commissioner, they lost largely, at least in my opinion. There's a lot of flaws that were in their strategy, but the reason why they lost has been largely due to the fact that they weren't able to prove how much time their property manager spent. All right. One less thing I'd say on audits is actually what I would say is arguably more risky than short term rentals is having bad books. Because oftentimes having Bad bookkeeping actually does trip you up in audits. Or if you can't generate clean financial statements to justify different things, the IRS will open up a can of worms on you. So bad bookkeeping is probably a bigger audit risk than using the short term rental strategy, assuming you document your position correctly, which I just mentioned. How to do. So before we get into the new the latest tax court case, let's just talk about why this is considered a loophole in the first place. Okay? Now the passive activity rules, also known as Section469, was put into place under the Tax Reform act of 1986 that was passed under President Ronald Reagan. And the passive activity rules basically stated that all rental activities are passive by default, meaning that you cannot take the losses from your rental properties against your W2 or your active business income. That's what it said. You can only take your rental losses against your other passive activities. Okay. And this specifically targeted primarily doctors and attorneys were noted as the targets, but it's pretty much any high income earner in general. So there was really no way to take your losses as non passive at that point. Subsequent law had the real estate professional status was put into Place in 1994 as a way for people who are working full time in real estate to take the losses from their rental properties against their other income. And the rationale behind that was that if a doctor, for example, could deduct their X ray machine against their business income from their medical practice, why can't I as a real estate professional deduct my rental losses against my development income, for example? And, and that opened up the door to taking losses from your rental properties as non passive. Right. And that particularly applies to midterm and long term rentals. And if you look at the real estate professional status, it is you must work more than 750 hours in a real property trader business and that must represent more than 50% of your total working time. So if you look at the intent and the explicit rules around that, very clearly geared towards people who are full time in real estate. So again, just to kind of recap it here in the tax reform Act, 1986 made all rental activities pass by default. Then the real estate professional status said, well, if you work full time in real estate, you can take your losses against your W2 income. So they were trying to prohibit people from taking losses from their rental properties against their W2 income. Now the regulations around the short term rental loophole were intended for hotels and motels. And if you think back to the late 80s, I'm sorry, I can't do that. I was, I'm a 90s baby. Think back to the late 80s and even the early to mid-90s. You know, it's very hard to foresee the ability to put a single family property that would otherwise be unmarketable as a short term rental, actually facilitate that. Right. Think about if you had a short term rental in your typical neighborhood, right? Imagine back then having to try to make that a short term rental, get an average period Customer use of 7 days or less and actually operate that in a way that would be profitable, quite challenging. But nowadays you have Airbnb, VRBO and a whole bunch of other online marketplaces that you can place your property up for rent and get an average day of seven days or less. So that's why people call it a loophole, because these rules are really, the intent was to limit your ability to take these losses as non passive. And then the rules that kind of made this short term rental exception is mainly for hotels and motels. Okay. And the framers of this law, I have to presume, did not fully, you know, probably weren't thinking to themselves, okay, you know, there's someone's going to eventually put this stuff on the Internet and be able to circumvent what we're kind of putting in place here. Again, you know, back in the 80s and 90s, operating a hotel and motel was a significant operation and they didn't foresee this kind of being used this way. That's why it's called a loophole, even though it's completely legitimate. Now let's move on to this new tax court case. This is Merck v. Commissioner T.C. memo 2025 128. And the article which I'm reading this on was published on 11th March of December 2025. Okay. And it involved the real estate professional status and the short term rental strategy. So the taxpayers in question were both attorneys and one of them was a certified public account, one of them was a cpa and they still got this wrong, you know, somewhat unbelievable. And what happened here is that they had two rental properties, one of which was a short term rental, the other one seems to be a long term rental. And, and they tried to argue that they were a real estate professional and they were able to deduct these losses as a real estate professional. And what the task court found is that their time log, their time log consisted of 12 minutes to read and 12 minutes to send every email, totaling 7.4 hours. Right. And also cleaning seven hours per turnover regardless of the length of stay, ranging from anywhere from 1 to 14 days totaling 168 hours and then site management 8 hours per day that the property is rented of being on call. So you could already see where this is going. On call has already been dismissed as being able to use those hours. So the tax court rejected the log as a ballpark guesstimate under a Moss v. Commissioner, another previous tax court case, the court also found that the seven hour of cleaning not to be credible, noting that the petitioners also deducted professional cleaning fees. So they were deducting professional cleaning fees, but claiming that they were actually cleaning the units themselves. They also determined that the on call hours does not count as material participation. Only actual time spent on the activity is countable and therefore the wife in this case failed to meet the 750 hour material participation requirement to be considered a real estate professional. Okay, the case continues. Right. So then the petitioners also argued that the short term rental property was non passive because it qualified as a short term rental with an average period of customers of seven days or less under Reg. Section 1.4691 TE3 CAP A. That is the short term rental loophole right there. That is the core of the strategy. And that was their case. But the court discredited their activity log due to the inflated cleaning and on call hours, saying that they failed to meet the 100 hours of material participation and therefore lost on that count. So seven days or less. Cool. But they failed to come up with a credible time log, which again is why it's so crucial to understand what counts as material participation, document your time correctly and realize that if you do ever make it to task court or you do ever, you know, God forbid, get audited that you're going to be asked to produce these documents. You have to remember that when you're dealing with tax strategies and tax planning and tax strategy in general, that this is not regular court. You're not innocent until proven guilty. You are guilty until proven innocent. You need to support your position for these strategies that you are are using. All right, so documenting your time is critical. All right, so that's the latest task court case. Now we're getting to the final leg of this episode here. Why is this still the number one strategy continued? Okay, so there's other strategies you can use to offset your W2 or your active business income. There is of course the real estate professional status. If you do have mid or long term rentals and either you or your spouse can qualify as a real estate professional, then you can take the losses from your mid or long term rentals against your W2 or your active business income if you or your spouse can qualify as a real estate professional. But this can often prove challenging for households where both spouses have jobs full time W2 jobs or running full time W2 businesses. Because again, one spouse under the real estate professional status still needs to spend more than 750 hours and more than 50% of their total working time. And 750 hours is still quite a bit of time. It's about 15 hours per week on average if you average it out for the year. So while real estate professional status Completely valid strategy, often not achievable for many couples who are again both working full time, then we have oil and gas. Oil and gas, another completely valid strategy. And this is actually one of the few strategies where you actually don't have to materially participate in oil and gas investments. You make the investment in the oil and gas working interest and the losses that are passed through from depreciation and the drilling fee, so on and so forth. We went through an entire series on this with Troy Eckerd and you can go ahead and check those episodes out and how oil and gas works. Legitimate strategy, but at the end of the day you are investing in oil and gas so you have to be comfortable with that investment. And that is another completely legitimate strategy to offset your W2 income. But why is short term rentals still the number one? Actually, let me cover one more thing first. There are some tax credit strategies out there, solar credits. There's also charitable giving strategies. However, what I found through my experience speaking with a lot of investors who are considering ways to reduce their W2 income is typically in wealth accumulation or asset accumulation mode. Meaning you don't really want to take assets out of your estate, if you will, and give it to the charities, at least at this point in time, your life, you often want to keep assets when you invest in a short term rental. If you operate that short term rental. If you acquire and operate that short term rental correctly, as we've went through on different episodes, including the episode we did with Taylor from Short term Rental search on how to acquire properties correctly, what markets to look at, et cetera. If you operate these properties correctly, you might be looking at property appreciation. You might also be looking at significant cash flow as a result. So these can be very profitable investments if executed correctly, in addition to the significant tax benefits you can receive for using the short term rental strategy. Whereas with charitable giving strategies you're taking money out and away from your state. Okay, and we just went through oil and gas. Viable reps, viable. But with short term rentals, you just need to buy a short term rental. Average period of customer use is seven days or less. Airbnb, vrbo, so on and so forth. Make that quite easy to do nowadays. And on top of that, often the test that most people use is going to be you spend more than 100 hours and no one else spends more time than you, which allows you to bring in cleaners, allows you to bring in repair people, what have you to help support you in this effort, as long as you spend more time than them. And a hundred hours or more than a hundred hours is significantly less than 750, which makes this the number one tax strategy not only for 2026, but I would argue for the foreseeable future. Okay? And again, nothing coming up the pipeline, at least that I could find anywhere or have heard at all over the last few years of changing these regulations that support this Strategy. And with 100% bonus depreciation back in play and made permanent, that is also supporting the strategy for the foreseeable future. So you could love it, you can hate it, doesn't matter. It's in my opinion the number one tax strategy for high income earners. One more strategy I forgot to mention here is you can buy a business, right? You could buy a laundromat, you could buy vending machines or buy a fleet of cars or whatever. You can depreciate those assets as well. But you're now you're running a different operating business. There's a lot more support and structure, at least in my opinion, around doing this, the short term rental strategy, but that's another viable strategy too. So that's kind of the playing field. And we went through an episode not too long ago where we went through an in depth look at all the W2 tax strategies that are available to taxpayers. You can go back and check that out in the archive of the show. But here's the reality when it comes to tax strategy and planning. We look at the tax code, the regulations, tax court cases, so on and so forth. There's only but so much creativity one can have within that playing field because it is, we are dealing with the law, right? And there are some area gray areas and areas where nuance and interpretation do exist or are required. But the reality is the real planning, the real planning comes into how do you apply all of these complex strategies to your specific situation? Right? Everybody has slightly different situations. The amount of income that you're earning other assets that you might be holding, what your lifestyle is, where you have kids, so on and so forth. And there's a lot more nuances even to these strategies than even what I'm talking about here today. What if you use personal use, how much time do you want to use it personally? What's your strategy for renting this out in the actual operation? So where tax strategy and planning comes into play is how do we look at the complex tax landscape and your individual situation and piece together all of these strategies and pieces of the puzzle in a way that not only gives, optimizes your taxes and help you significantly reduce your taxes, but but does it in a way that ensures that you're compliant so that if, God forbid, an audit ever does come your way, this is an open and shut easy win case for you. That's where a good tax advisor comes in. Okay, so if you're a high income W2 earner or you're running a business that's generating significant income, you have a significant tax liability as a result, and you're only working with a tax preparer, chances are you're leaving money on the table because they're not giving you proactive advice on what strategies that you can use. They might even be telling you that you can't use legitimate strategies that are available to you. And secondly, we see this all the time. They could be making significant errors within your tax return that could be costing you a lot of money. So that's why working with a tax advisor is so important, because you want to ensure that you're not leaving money on the table, that you're taking advantage of the strategies you are entitled to and you're doing it that is in a way that is above board with the irs. So if you're not currently working with a tax advisor, and it's currently the top of 2026, I'm recording this episode, the very beginning of 2026. And now's a great time to start planning for 2026 and the years ahead. So you have plenty of time to execute these strategies and end the year on the right note, right? That, hey, we did everything we could within reason to reduce our taxes. We're putting ourselves in good shape. We're have reduced taxes, which means more tax savings, which means we can invest more, we can go on more vacations, we can buy that car we've been waiting to buy, whatever the case may be for you, whatever you want to use the additional tax savings for. Again, we've helped clients save one client case studies right on the realestatecpa.com the case study is one client we help them save roughly $130,000 with one short term rental and their client saves significantly more to the tune of over $300,000 on one short term rental over the course of a few years thanks to net operating losses. So the the the tax savings from the strategy are significant. It's not going anywhere and it is, in my opinion, the number one tax strategy. So that's it for today. If you if you do want to talk to us, see if we can help you reduce your taxes, you'd follow the link in the show notes to this episode and we would love to have a conversation to learn more about what you have going on and see how we can help. Thanks again for tuning in and we'll catch you on next week's episode of the Tax Smart REI podcast. The TechSmart Real Estate Investors Podcast is for general information purposes only and is not intended to provide and should not be relied upon for tax, legal or accounting advice. Information on the podcast may not constitute the most up to date legal or other information. No reader, user or listener of this podcast should act or refrain from acting on the basis of the information on this podcast without first seeking legal and tax advice from counsel in the relevant jurisdiction, use of and access to this podcast or any of the links or resources contained or mentioned within the podcast, show or show Notes do not create a relationship between the reader, user or listener of the podcast and the host, contributors or guests. Any mention of third party vendors, products or services does not constitute an endorsement or recommendation. You should conduct your own due diligence before engaging any vendor. For more information, reference the show notes or description of this episode.
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