Client Profile
| Industry | Short-Term Rental Investor |
| Portfolio | 5 Properties (Combined basis: $2.4M) |
| Entity Type | Individual + LLCs |
| State | Tennessee |
| Key Metric | $200K active income offset in Year 1 |
| Tax Savings | $200,000 in active income offset |
The Problem
This client owned 5 short-term rental properties in popular vacation markets across Tennessee and the Smoky Mountains region. The properties were generating gross rental income of approximately $380,000 per year with net cash flow of about $95,000. However, the client also operated a consulting business generating $200,000 in active income — and their prior CPA had classified all rental losses as passive.
The prior CPA was not aware that short-term rentals with average guest stays of 7 days or less are exempt from the passive activity rules under IRC §469(c)(2) when the owner materially participates. No cost segregation studies had been conducted on any of the five properties.
AE Tax Strategy
1. Short-Term Rental Exception Under IRC §469(c)(2)
We documented that all five properties had average guest stays of 7 days or less, qualifying them for the short-term rental exception under IRC §469(c)(2). Under this provision, rental activities with average rental periods of 7 days or less are treated as business activities, not rental activities for passive loss purposes.
2. Material Participation Documentation Under Treas. Reg. §1.469-5T(a)
We implemented a contemporaneous time-tracking system. The client logged over 750 hours across the five properties, satisfying the 500-hour material participation test under Treas. Reg. §1.469-5T(a)(1).
3. Cost Segregation Studies Under IRC §168
We commissioned cost segregation studies on all five properties (combined depreciable basis of $2.4 million). The studies reclassified approximately $840,000 to accelerated recovery periods. With bonus depreciation, this produced first-year accelerated deductions of $840,000.
4. Grouping Election Under IRC §469(c)(3)
We filed a grouping election under IRC §469(c)(3) to treat all five STR properties as a single activity, allowing aggregation of material participation hours and loss consolidation across properties.
Before & After Comparison
| Category | Before | After | Impact |
|---|---|---|---|
| Rental Activity Classification | Passive | Non-Passive | Losses unlocked |
| Year 1 Depreciation | $87,000 | $927,000 | +$840,000 |
| Active Income Offset | $0 | $200,000 | $200,000 |
| Estimated Tax Savings | $0 | $74,000 | $74,000 |
Key Takeaways
- Short-term rentals with average guest stays of 7 days or less are not automatically passive activities — this exception under IRC §469(c)(2) is one of the most powerful provisions for STR investors.
- Material participation must be documented contemporaneously — a year-end estimate of hours will not survive IRS examination.
- Cost segregation on STR properties creates accelerated depreciation that, when combined with non-passive treatment, can directly offset W-2 or business income.
- Grouping elections are irrevocable and must be filed in the first year — planning this election upfront is critical for portfolio-level optimization.