Your Airbnb Lost Money. Here's Why You Can't Deduct It (And How to Fix It).

You have a short-term rental (STR) that generated a loss on paper. Your first instinct is to use that loss to reduce the taxes on your primary salary. That instinct is likely wrong and could lead to a costly audit.

Under Internal Revenue Code §469, losses from these passive activities are quarantined; they cannot offset your non-passive income, such as W-2 wages or profits from a business you actively run. These are the Passive Activity Loss (PAL) rules. To deduct your STR losses against your active income, you must navigate a series of rigorous tests to prove your operation is not a passive investment but an active business. The burden of proof is entirely on you.

Step 1: Escaping the "Rental Activity" Classification

Your first objective is to prove your STR is not a "rental activity" as defined by the tax code. If you succeed, you escape the automatic passive designation that traps traditional landlords. The two primary escape hatches are found in Treasury Regulation §1.469-1T(e)(3).

• The 7-Day Rule: This is the most common path. Your property is not considered a rental activity if the average period of customer use is seven days or less. This is a straightforward mathematical test: Total days rented / Total number of individual stays. For example, a mountain cabin rented 40 times for a total of 120 nights has an average stay of 3 days (120 ÷ 40). It easily passes this test and is not a "rental activity."
• The 30-Day Rule with Significant Services: This is the second path. Your property is also not a rental activity if the average customer use is 30 days or less AND you provide significant personal services. This is a high standard. "Significant personal services" are hotel-like amenities that go far beyond standard landlord duties.
  • Examples of Significant Services: Daily cleaning, changing linens during a guest's stay, providing meals, or arranging tours and local transportation.
  • What Does NOT Qualify: Providing utilities, cleaning the unit between stays, stocking basic toiletries, or performing routine maintenance. These are considered incidental to the property rental itself, not significant services provided to the guest.

Clearing one of these hurdles is the mandatory first step. It is also why Real Estate Professional (REP) status under §469(c)(7)(A) is irrelevant for this specific strategy. REP status is a separate rule that allows qualifying individuals in real property trades to treat their traditional long-term rentals as non-passive. Think of REP status as a key for the "Long-Term Rental" door. If your STR meets the 7-day or 30-day exception, you are using a different entrance labeled "Business Operations," where the REP key is useless.

Step 2: Proving Material Participation

Escaping the rental definition is not enough. You must still prove you materially participated in the business. This is how you demonstrate you are the active operator, not a passive investor. Your spouse's hours can be combined with yours to meet these tests (§469(h)).

You must meet one of the seven tests found in Temp. Reg. §1.469-5T(a). For STR owners, these three are the most common and defensible:

1. The 500-Hour Test: You (and your spouse) participated in the activity for more than 500 hours during the year. Qualifying activities include all aspects of operations: marketing, guest communication, managing listings, coordinating cleaners, shopping for supplies, performing maintenance, travel time, and bookkeeping.
2. The Substantially All Participation Test: Your participation constituted substantially all of the participation in the activity. If you are the sole operator—handling everything from bookings to cleaning—and the only outside help is for isolated incidents like a plumbing emergency, you meet this test.
3. The 100-Hour Test: You participated for more than 100 hours, and that was more than any other single individual. This test is a trap for the unwary. You must track not only your own hours but also the hours of anyone else who works on the property. If you spend 150 hours on management but your primary cleaner works 160 hours over the year, you fail this test.

Documentation is your defense. The IRS and Tax Courts view post-hoc estimates of time with extreme skepticism. If you don’t have credible, contemporaneous records, your claim of material participation will likely be denied in an audit. Your evidence file should include time logs, calendars, invoices, guest communication records, receipts, and third-party statements that corroborate your active involvement.

The Financial Stakes: Why This Classification Is Crucial

Correctly classifying your STR as a non-passive business has multiple financial consequences, both positive and negative.

1. Full Loss Deductibility: The primary benefit is using the losses to directly offset your active income (e.g., W-2 wages, other business income), significantly lowering your overall tax bill.
2. Avoiding the Net Investment Income Tax (NIIT): The NIIT is an additional 3.8% surtax levied on passive investment income for taxpayers above certain income thresholds (§1411). By properly classifying your STR as a non-passive business, its net income is generally excluded from this tax, providing an extra layer of savings.
3. Potential for Self-Employment Tax: This is the potential downside. If your STR is a non-passive trade or business, its net income may be subject to self-employment taxes (Social Security and Medicare). This is a critical point to discuss with a tax professional, as it can offset some of the benefits on profitable properties.

Critical Traps and Alternate Scenarios

Navigating §469 is complex, and several related rules can act as traps or provide different outcomes if you fail to qualify.

• WARNING: Personal Use Can Kill Your Deductions. Under §280A, if you use your STR for personal purposes for more than the greater of 14 days or 10% of the days it was rented, it may be classified as a "vacation home." This triggers rules that limit your expense deductions to the amount of rental income, completely eliminating your ability to claim a net loss, regardless of your material participation.
• What If I Don't Qualify? The $25,000 Special Allowance. If your property remains a passive rental activity (e.g., average stay is over 7 days), you might still deduct up to $25,000 in losses if you "actively participate." Active participation is a lower standard than material participation (e.g., making management decisions like approving tenants and repairs). However, this allowance is phased out for taxpayers with an Adjusted Gross Income (AGI) between $100,000 and $150,000 and is unavailable for those with an AGI above $150,000 (§469(i)).
• What If My Losses Are Suspended? The Disposition Rule. If you have suspended passive losses that you've been unable to use, a fully taxable sale of your entire interest in the property unlocks them. Under §469(g), the tax code allows all previously suspended losses to be realized in the year of sale, offsetting any type of income.

As of late 2025, no significant legislation has been passed to alter these fundamental §469 rules for short-term rentals. The framework described here remains the current law and the standard to which you will be held.

Disclaimer: This information is for educational purposes only and is not tax or legal advice. The Internal Revenue Code is complex and subject to change. Consult your tax Advisor to review your specific facts and circumstances.