Short-Term Rental Loophole Gets Stronger With Permanent 100% Bonus Depreciation

What changed

The One Big Beautiful Bill Act (OBBBA, P.L. 119-21, signed July 4, 2025) permanently restored 100% first-year bonus depreciation for qualifying property acquired after January 19, 2025. Under interim guidance in IRS Notice 2026-11 (January 14, 2026), investors can rely on that rule for property with a MACRS recovery period of 20 years or less — the five-year personal property and 15-year land improvements that a cost segregation study identifies inside a rental building. Previously the TCJA bonus rate was phasing down: 40% for property placed in service in 2025 and 20% in 2026 under the old schedule for property under binding contract before January 20, 2025. The OBBBA eliminated the phase-down for newly acquired property entirely. 24/7 Wall Street reported on October 30, 2026 that this development directly strengthens the short-term rental tax strategy for investors.

Why it matters to investors

The short-term rental (STR) tax strategy stacks two separate provisions. First, under 26 CFR § 1.469-1T(e)(3)(ii)(A), a rental property where the average guest stay is seven days or less falls outside the definition of a “rental activity” under the passive activity loss (PAL) rules. If you also materially participate in that activity — generally, spending more than 500 hours per year or meeting another test under Treas. Reg. § 1.469-5T — any operating loss from the property is non-passive and can offset W-2 wages, business income, or other active-income sources. Without both conditions, rental losses are passive and can only offset passive income.

Second, a cost segregation study reclassifies personal-property components — appliances, flooring, furniture, certain fixtures — from the 27.5-year residential building into five-year property, and land improvements (parking, landscaping, walkways) into 15-year property. With permanent 100% bonus depreciation now available under Notice 2026-11, all of those reclassified components may be expensed in the year the property is placed in service.

Concretely: suppose an investor purchases a short-term rental for $600,000, with $100,000 allocated to land and $500,000 to depreciable improvements. A cost segregation study identifies $180,000 of five-year personal property and $60,000 of 15-year land improvements, leaving $260,000 as the 27.5-year building shell. The $240,000 of reclassified components qualifies for 100% first-year bonus depreciation. For an investor in the 37% federal bracket who materially participates and averages fewer than seven days per guest stay, that deduction offsets $240,000 of active income — roughly $88,800 in immediate federal tax deferral. The strategy existed before, but the phase-down to sub-100% rates had reduced its magnitude; permanent 100% bonus depreciation fully restores it. Sources: 24/7 Wall Street, October 30, 2026; IRS Notice 2026-11, January 14, 2026 (summarized by CBIZ); IRS Publication 925, Passive Activity and At-Risk Rules.

What to do

Verify your average-stay data before year-end. The seven-day average-stay test is the gateway to non-passive treatment. If your booking records show an average above seven days, the non-passive designation is unavailable regardless of the size of the depreciation deduction.

Document material participation contemporaneously. Short-term rental material participation is a known IRS audit focus area. Keep a contemporaneous log of hours spent on the activity — guest communications, maintenance coordination, listing management, cleaning oversight. Notes assembled after the fact carry less weight on examination.

Commission a cost segregation study before the property is placed in service. Bonus depreciation is claimed in the year of placement in service. Missing the window means losing the accelerated deduction for those components; a retroactive catch-up requires filing Form 3115 in a later year, and the applicable bonus percentage for prior-year components differs from the current 100% rate.

Model the Section 1245 recapture before you sell. Five-year and 15-year components expensed via cost segregation are § 1245 property. Their depreciation is recaptured as ordinary income at sale — at your full marginal rate, not the 25%-capped rate that applies to the building shell. The strategy is a tax-deferral tool; a 1031 exchange or a step-up in basis at death can further defer or eliminate the eventual recapture.

Educational context only — not tax advice. Primary sources: 24/7 Wall Street, October 30, 2026; IRS Notice 2026-11, January 14, 2026; IRS Publication 925. Consult a qualified tax professional before acting.

A worked example from purchase to tax return

Return to the $600,000 short-term rental from the prior section and follow the numbers through an actual return. The investor closes in March 2026, lists the property on booking platforms, and has it available for guests by April — the placed-in-service date, which is what controls depreciation, not the purchase date. A cost segregation study completed before the first guest allocates $100,000 to land (never depreciable), $180,000 to five-year personal property, $60,000 to 15-year land improvements, and $260,000 to the 27.5-year building shell.

The $180,000 of five-year property and $60,000 of 15-year land improvements — $240,000 combined — are reported on Form 4562 and expensed in full under 100% bonus depreciation. The 27.5-year shell depreciates normally, contributing roughly $5,400 of regular MACRS depreciation for a partial first year. Net depreciation for year one is about $245,400. Suppose the property throws off $40,000 of gross rents against $22,000 of operating costs (cleaning, supplies, management, utilities, insurance, mortgage interest). Before depreciation the activity nets positive $18,000; after the $245,400 depreciation deduction it shows a loss of roughly $227,400.

Because the average guest stay is under seven days and the owner materially participates, that loss is non-passive. It flows from Schedule E to the front of Form 1040 and offsets the owner’s wages and other active income — subject to the at-risk and excess-business-loss limits discussed below. For a taxpayer in the 37% bracket, sheltering that much income is worth roughly $84,000 in first-year federal tax, before any state benefit. The cash did not disappear; it was converted into depreciation deductions pulled forward from future years, which is why planning for the eventual recapture is part of the same decision.

Why this strategy does not require real estate professional status

The most common point of confusion is the relationship between the STR strategy and real estate professional status (REPS). REPS — which requires more than 750 hours and more than half of personal-service time in real property trades or businesses under IRC § 469(c)(7) — is the route long-term landlords use to make their rental losses non-passive. The short-term rental strategy does not use that route at all.

The reason is structural. A rental with an average guest stay of seven days or fewer is not a rental activity under the regulations in the first place, so the special rule that automatically treats rental activities as passive never applies to it. The owner only has to clear the ordinary material-participation bar — most commonly the 500-hour test — the same standard any active business owner meets. That is why a full-time employee with a W-2 job can still use the STR strategy: 500 hours a year across a busy season is achievable for someone with a demanding day job, whereas the 750-hour REPS test with its more-than-half-of-working-time requirement is effectively impossible for a full-time employee.

This distinction is also why the strategy is sometimes marketed aggressively. The gap between “500 hours on one short-term rental” and “750 hours and a majority of your working life in real estate” is enormous, and it is the single feature that makes the STR approach viable for high earners who are not real estate professionals.

The material-participation tests in detail

Material participation is defined by seven tests in Treas. Reg. § 1.469-5T(a), and meeting any one of them is sufficient. The three that matter most for short-term rentals are: (1) you participate more than 500 hours in the year; (2) your participation constitutes substantially all of the participation by everyone in the activity; or (3) you participate more than 100 hours and no other individual participates more than you do.

Tests (2) and (3) are the practical lifelines for smaller operations. An owner who personally handles guest messaging, scheduling, and vendor coordination for a single property — even if total hours fall short of 500 — may still qualify if no cleaner, co-host, or manager spends more time on the activity than the owner does. This is also why owners who outsource everything to a professional short-term-rental management company often fail material participation: the management company’s staff participate more than the owner, defeating tests (2) and (3), and the owner rarely reaches 500 hours of genuine involvement on their own.

Hours that count include advertising and listing management, screening and communicating with guests, arranging cleaning and maintenance, bookkeeping specific to the property, and being on call for guest issues. Hours that generally do not count include travel to and from the property, time spent as an investor merely reviewing financial statements, and — when you are establishing your own participation — time your employees spend. Spousal hours are combined for determining whether a couple materially participates, which often pushes a jointly operated rental over the line.

State tax treatment: not every state follows the federal rule

A large first-year federal deduction does not automatically produce an equal state deduction. Many states decouple from federal bonus depreciation, meaning they do not conform to IRC § 168(k). In those states the taxpayer adds the bonus amount back to state taxable income and instead depreciates the components over their normal recovery periods on the state return, recovering the deduction slowly rather than all at once.

California is the most consequential example: it has never allowed bonus depreciation and does not conform to § 168(k) at all, so a California short-term-rental owner gets the full federal benefit but no first-year state acceleration. Other states — such as New York, which requires its own depreciation addback and subtraction schedule — create a permanent set of state-versus-federal timing differences that must be tracked for the life of the asset. States with no individual income tax (Texas, Florida, Tennessee, and others) make the question moot for resident individuals.

The practical consequence is that the headline federal tax savings overstate the all-in benefit for an owner in a high-tax, non-conforming state, and understate the record-keeping burden. Model the state result separately; the federal and state depreciation schedules will diverge and stay divergent until the property is sold.

How the deduction interacts with other limits

A loss that survives the passive-activity rules still has to clear several more gates before it offsets wages. The at-risk rules of IRC § 465 limit your deductible loss to the amount you have economically at risk — generally your cash invested plus recourse debt you are personally liable for. Nonrecourse financing on the building can cap the loss you can currently use, deferring the excess until you have more at-risk basis.

The excess business loss limitation of IRC § 461(l), which the OBBBA made permanent, caps how much net business loss can offset non-business income in a single year. For 2025 the threshold is $313,000 for single filers and $626,000 for joint filers, adjusted for inflation in later years. A $227,400 loss like the one in the worked example falls under the cap and is fully usable; a larger loss, or several cost-segregated properties placed in service the same year, could exceed it. Any disallowed excess is not lost — it converts into a net operating loss carried forward to future years.

On the upside, two other provisions can improve the picture. If the activity rises to a trade or business, the income it eventually produces may qualify for the 20% qualified business income (QBI) deduction under § 199A, also made permanent by the OBBBA. And a materially participated short-term rental that is a trade or business is generally outside the reach of the 3.8% net investment income tax, whereas a passive rental’s income and gain can be exposed to it. These interactions are fact-specific and are exactly where a CPA’s modeling earns its fee.

Common mistakes that sink the strategy

The error that generates the most assessed tax is treating the seven-day test casually. The average is computed across all guest stays over the year, and a few long bookings can drag the average above seven days without the owner noticing. If a property marketed as a short-term rental actually averaged, say, nine days per stay, the entire non-passive treatment collapses on audit and the losses revert to passive — usable only against passive income.

A second trap is the Schedule C versus Schedule E question. A short-term rental is normally reported on Schedule E and is not subject to self-employment tax. But if the owner provides substantial services comparable to a hotel — daily cleaning during a stay, meals, concierge service — the IRS may recharacterize the activity as a trade or business reported on Schedule C and subject to 15.3% self-employment tax. Owners chasing material-participation hours sometimes add services that inadvertently trip this line.

Other recurring errors: claiming bonus depreciation in a year the property was not actually placed in service (purchased in December but not available to guests until the following spring); ignoring personal-use days, which reduce the deductible portion and can trigger the vacation-home rules of § 280A; and assembling a material-participation log after receiving an audit notice rather than contemporaneously. Each of these is routine for examiners to check, and each can unwind the strategy after the deduction has already been spent.

The bottom line

Permanent 100% bonus depreciation does not create a new loophole; it restores the full strength of one that already existed. The three pillars are unchanged: a seven-day-or-less average stay to escape the rental-activity classification, material participation to make the loss non-passive, and a cost segregation study to maximize the components eligible for first-year expensing. What the OBBBA changed is magnitude — the deduction is 100% again rather than the 40% it was scheduled to be in 2025 — and permanence, which removes the year-to-year uncertainty that complicated planning under the old phase-down.

The strategy remains a tax-deferral tool, not a tax-elimination tool, because the accelerated deductions are recaptured as ordinary income when the property sells. The owners who benefit most are those who pair it with a long hold, a future low-income year, a 1031 exchange, or a step-up in basis at death — and who document the seven-day average and their participation hours well enough to survive the audit the strategy predictably attracts.

Frequently asked questions

Does permanent 100% bonus depreciation eliminate the seven-day average-stay requirement?

No. The seven-day average-stay test derives from the passive activity regulations (26 CFR § 1.469-1T(e)(3)(ii)(A)), not the depreciation rules. You must still average seven days or fewer per guest AND materially participate for losses to be non-passive and offset active income. Bonus depreciation only increases the size of the deduction once both thresholds are satisfied.

Will the bonus depreciation I claim on a short-term rental be recaptured at sale?

Yes. Personal-property components reclassified by a cost segregation study and expensed via bonus depreciation are Section 1245 property. On sale, the depreciation claimed is recaptured as ordinary income up to the gain on those components, at your full marginal rate with no 25% cap. The strategy accelerates deductions into year one and defers the tax cost to a future disposition — a 1031 exchange or step-up in basis at death can further defer or permanently eliminate the eventual recapture.

Do I need to be a real estate professional to use the short-term rental strategy?

No, and that is the central point. Real estate professional status under IRC § 469(c)(7) requires more than 750 hours and more than half of your personal-service time in real property businesses — a bar a full-time employee effectively cannot meet. The STR strategy does not use that route. Because a rental with an average stay of seven days or fewer is not a “rental activity” under the regulations, you only need to meet an ordinary material-participation test, most commonly the 500-hour test, to make the loss non-passive.

Is a short-term rental reported on Schedule C or Schedule E?

Usually Schedule E, which means the income is not subject to the 15.3% self-employment tax. It moves to Schedule C only if you provide substantial hotel-like services — daily housekeeping during a stay, meals, concierge service — which causes the IRS to treat the activity as a trade or business subject to self-employment tax. Most owners who provide only standard turnover cleaning between guests remain on Schedule E.

Can bonus depreciation create a loss larger than my rental income?

Yes. Bonus depreciation frequently produces a first-year loss far exceeding the property’s net rents, and if you pass the seven-day and material-participation tests that loss is non-passive and can offset wages or business income. The loss must still clear the at-risk rules of § 465 and the excess business loss limitation of § 461(l), which for 2025 caps the offset of non-business income at $313,000 (single) or $626,000 (joint). Any disallowed amount becomes a net operating loss carried forward rather than a permanent loss.

Will every state let me deduct the full 100% bonus depreciation?

No. Many states decouple from federal bonus depreciation and require you to add it back, then depreciate the components over their normal lives on the state return. California does not allow bonus depreciation at all; states such as New York require their own addback-and-subtraction schedule. States with no individual income tax make the issue moot. Always model the state result separately, because your federal and state depreciation schedules will diverge until you sell.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.