Short-Term Vacation Rentals and Material Participation

Real estate can offer significant tax benefits. This is largely due to depreciation deductions which allow taxpayers to deduct their cost of investment in the property.

Given the tax benefits, Congress has put in place some nuanced rules that allow some real estate owners to get immediate benefits and that deny or defer benefits to others. The short-term rental exception is an example of this.

Under the short-term rental rules, real estate owners are able to get immediate tax deductions for their real estate. Unlike traditional long-term residential rentals, which are automatically treated as passive activities, short-term rentals can escape this characterization. This creates an opportunity for taxpayers to deduct rental losses against their ordinary income. The problem is that the exception doesn’t work automatically. Even when a property qualifies as a short-term rental, the taxpayer must still prove material participation in the rental activity.

The recent case Mirch v. Commissioner, T.C. Memo. 2025-128 (2025), provides an opportunity to examine how a short-term property owner should go about documenting their hours to establish material participation.

Facts & Procedural History

The taxpayers were married attorneys who operated a law firm in Reno, Nevada. They owned a single-family home next door to their residence. They rented it out as a vacation rental property with an average rental period of less than seven days. The property was rented approximately 23 times for a total of 93 days during the year. In addition to rental income, they advertised a cleaning fee of $80 to $100 per stay and hired professional cleaning and landscaping services.

The taxpayers reported a loss of $32,565 from the Reno rental activity on Schedule E. They treated this loss as nonpassive and used it to offset their nonpassive income from their law firm. The IRS selected their 2006 return for audit as part of a broader examination that included multiple years. The audit resulted in several proposed adjustments, including treatmenting the rental losses as passive, and therefore not available to offset the law firm income for tax purposes.

After the audit, the taxpayers filed a protest with the IRS Office of Appeals. IRS Appeals sustained the adjustments, and the IRS issued a Notice of Deficiency determining a deficiency of $99,862 for 2006. The taxpayers did not file a petition with the U.S. Tax Court within the 90-day period. The IRS assessed the deficiency and subsequently filed a Notice of Federal Tax Lien.

The taxpayers requested a collection due process (“CDP”) hearing to challenge the IRS tax lien. Because they had not received the Notice of Deficiency (it was returned to the IRS as unclaimed by the postal service), they were able to challenge their underlying tax liability during the CDP hearing. The case eventually ended up in trial in the U.S. Tax Court, where the court considered whether the 2006 tax liability was owed.

Section 469 and the Passive Activity Loss Rules

Section 469 of the tax code limits deductions for passive activity losses. The provision generally prevents taxpayers from using losses from passive activities to offset their nonpassive income such as wages, business income, and investment income. A passive activity is defined as any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate.

These passive loss limitation rules were enacted to prevent perceived tax shelter abuses. Before these rules, taxpayers could invest in activities designed to generate losses (often through accelerated depreciation) and use those losses to offset their salary and business income. The passive loss rules attempted to put a stop to this in certain defined situations by segregating passive losses into a separate basket. With the rules, passive losses can only offset passive income. Any excess passive losses are suspended and carried forward to future years until the taxpayer has sufficient passive income or disposes of the entire interest in the activity.

The Treasury regulations provide seven specific tests for determining whether a taxpayer materially participates. If the taxpayer satisfies any one of these seven tests, the activity is not passive. The taxpayer’s losses from the activity can then offset other types of income. The statute defines material participation as regular, continuous, and substantial involvement in the activity’s operations, which we’ll address more below.

The Nuanced Rules for Rental Activities

Section 469 also includes several nuanced rules for rental activities. The rules for rental activities reflect the view that rental real estate is inherently passive in nature. Unlike an operating business where the owner’s active involvement drives profits, rental real estate generates income primarily from the capital investment in the property rather than from the owner’s personal efforts. This is no doubt why Congress chose to treat rental activities differently from other trades or businesses.

The general rule is that rental activities are treated as per se passive regardless of whether the taxpayer materially participates. This means that even if a landlord spends 1,000 hours managing rental properties, the rental losses could still be passive under the general rule. If they are, the rental losses can only offset passive income from other activities.

The per se passive treatment creates problems for taxpayers who actively manage their rental properties. Many landlords spend considerable time finding tenants, handling maintenance, collecting rent, and dealing with property issues. Despite this involvement, their rental losses may be passive and not offset their wages or business income. This can be extremely unfair to taxpayers who are actively running a rental business.

The Short-Term Rental Exception

This brings us to the short-term rental exception. The rules say that activities involving short-term rentals are not treated as rental activities at all.

A short-term rental is defined as property where the average period of customer use is seven days or less. Common examples include hotels, bed and breakfasts, and vacation rentals advertised on platforms like Airbnb or VRBO.

Because short-term rentals are excluded from the definition of rental activities, they are not automatically passive. This allows short-term rentals to sidestep some of the passive activity loss rules. They are treated like any other trade or business activity. This means the taxpayer must determine whether they materially participate in the short-term rental activity using the standard seven tests that apply to all businesses. If the taxpayer materially participates, the losses are nonpassive and can offset ordinary income.

The rationale for this exception is that short-term rentals more closely resemble service businesses than passive investments. When a property is rented for very short periods, the owner typically provides significant services to guests. These services might include cleaning between stays, providing linens and toiletries, responding to guest inquiries, and handling check-ins and checkouts. The level of services and involvement is more like running a hotel than simply collecting rent from a long-term tenant.

Material Participation Requirements Still Apply

Many taxpayers misunderstand the short-term rental exception. They believe that simply having a property with an average rental period of seven days or less automatically makes their losses nonpassive. This is incorrect. The short-term rental exception merely removes the per se passive characterization that applies to traditional rentals. The taxpayer still has to prove that they materially participipated using the same tests that apply to any trade or business.

As noted above, the regulations set out seven different tests for material participation. The taxpayer only needs to satisfy one of these tests to be treated as materially participating. The tests range from very stringent requirements (more than 500 hours of participation) to more flexible standards based on facts and circumstances. Each test provides a different way to establish material participation.

The first test requires participation for more than 500 hours during the year. This is the most straightforward test and the one most commonly used by full-time business owners. The second test requires that the taxpayer’s participation constitute substantially all of the participation by all individuals for the year. This test is difficult to meet when the business has employees or other participants.

The third test is the 100-hour test. The taxpayer must participate for more than 100 hours during the year, and the participation must not be less than any other individual’s participation. The fourth test involves “significant participation activities” where the taxpayer participates for more than 100 hours and the aggregate participation across all such activities exceeds 500 hours. The fifth test allows material participation if the taxpayer materially participated in the activity for any five years during the prior ten years.

The 100-hour test provides a relatively low threshold for material participation. The taxpayer needs to show participation exceeding 100 hours and that their participation is not less than any other individual. This test appeals to taxpayers with short-term rentals because 100 hours is often easily achievable even for a property rented only part of the year.

The sixth test applies to personal service activities and allows material participation if the taxpayer materially participated for any three prior years. The seventh test is a facts and circumstances test that looks at whether the taxpayer participates on a regular, continuous, and substantial basis during the year. This last test has limitations. The taxpayer must participate for at least 100 hours, and management activities don’t count if any other person is compensated for management services.

The Court’s Analysis of the Reno Property Hours

This brings us back to this case. The taxpayers presented an undated log claiming the taxpayer-wife worked 944.5 hours on the Reno rental activity during 2006. The log used a summary method that assigned standardized time estimates to three categories of tasks: emails, cleaning, and site management. The court examined each category separately to determine whether the hours were reasonable.

For emails, the log allocated 12 minutes to read each email and 12 minutes to send each email, totaling 7.4 hours for the year. The court found this reasonable based on evidence showing the number of emails exchanged with prospective tenants. The wife advertised the property on rental websites and responded to inquiries. The standardized 12-minute allocation per email was plausible given the need to answer questions and coordinate rental details.

The cleaning hours presented a different picture. The log claimed 7 hours of cleaning after each of the 23 rental stays for a total of 168 hours. The court noted several problems with this claim. The taxpayers deducted nearly $10,000 for professional cleaning services on their Schedule E. They also charged renters a separate $85 cleaning fee for most stays. The economic evidence suggested they hired others to clean the property rather than doing it themselves.

The court also questioned whether 7 hours was reasonable regardless of who did the cleaning. The standardized 7-hour estimate applied to every stay, whether the rental lasted one day or fourteen days. A property rented for one night presumably requires less cleaning than one rented for two weeks. The inflexible time estimate undermined the credibility of the log. The court concluded the wife likely performed minimal cleaning hours at most, and characterized the 168-hour claim as a post-event ballpark estimate that could not be credited.

The most problematic category was site management. The log claimed 8 hours of site management for each of the 93 days the property was rented, totaling 744 hours. The log defined site management as being “on call for guests, repairs, supplies, Wi-Fi, cable, snow removal.” This category alone accounted for nearly 80% of the claimed hours.

The court rejected these hours entirely. Being available or on call does not count as participation. Only actual time spent working on the rental activity counts toward participation hours. The regulations require identifying the actual services performed and the approximate time spent performing them. Simply being available to handle issues that might arise does not satisfy this requirement.

The court acknowledged the wife likely performed some tasks while guests occupied the property. She probably answered questions, coordinated repairs, or addressed issues that came up. The problem was the lack of any evidence showing what she actually did or how long each task took. The standardized 8-hour per rental day allocation had no connection to reality. There was no calendar, no log of specific tasks, and no contemporaneous documentation of work performed.

The court noted that it would need to assign close to one hour per rental day to site management for the wife to reach 100 hours total and even this reduced estimate lacked support in the record. According to the court, the wife failed to maintain adequate records and did not provide credible testimony about her actual hours. The court cited cases holding that taxpayers cannot rely on post-event ballpark estimates lacking specificity about when work was performed.

The Problem with Standardized Time Allocations

This case is really about substantiation. The taxpayers’ hours log failed because it used standardized time allocations that didn’t reflect actual work performed.

Assigning the same number of hours to every occurrence of a task (7 hours for every cleaning, 8 hours for every rental day) creates an immediate credibility problem. Real work doesn’t happen in neat, identical increments. Some tasks take longer than others depending on circumstances.

Standardized allocations suggest the hours were calculated to reach a desired total rather than documented based on actual time spent. This is particularly true when the standardized allocation is a round number like 7 or 8 hours. Real activities tend to take irregular amounts of time: 45 minutes here, 2 hours there, maybe 6 hours on a busy day. When every entry is the exact same round number, it looks like someone working backward from a target rather than tracking actual time.

The court’s opinion emphasized that the summary method used by the taxpayers was “far from reasonable.” The log did not accurately reflect actual participation and was not reliable. Courts give taxpayers flexibility in how they document their hours, but the documentation must bear some relationship to reality. Standardized allocations that ignore the actual facts and circumstances of each task will not survive scrutiny during tax audits or tax litigation.

The Takeaway

The short-term rental exception to the passive loss rules allows most short-term rental real estate owners to get immediate tax benefits from their properties. This allows the owners to deduct losses against their ordinary income, but they can only do so if they can prove material participation. The exception works best for owners who provide substantial services to guests and who maintain proper documentation of their involvement. For those who own short-term rental units, they know that success with these units does take significant time. Thus, the 100 hour test, for example, is often very easy to meet. The only question is what substantiation is needed. This case helps clarify what records are insufficient in this regard. Standardized time allocations that bear no relationship to reality will not work and being on call or available doesn’t count as participation time is actually spent working on the activity.

Watch Our Free On-Demand Webinar

In 40 minutes, we'll teach you how to survive an IRS audit.

We'll explain how the IRS conducts audits and how to manage and close the audit.  

Register Now