By Jamie Melgar
On a $3 million to $10 million vacation home, the short-term rental strategy can produce a six-figure first-year deduction. It can also fail quietly, and owners often find out only years later.
Few real estate strategies have drawn as much attention from high earners. Buy a home in Aspen, Scottsdale or the Hamptons, rent it by the weekend, and, handled correctly, the depreciation can offset ordinary income rather than remaining trapped as a passive loss. The strategy has three moving parts, and luxury properties tend to strain every one of them.
How the strategy works
Rental income is ordinarily passive, and passive losses can only offset passive income. Certain short-term rental activities can fall outside the passive activity regulations’ definition of a rental activity. Most notably, under what is often called the seven-day rule, a property whose average guest stay is seven days or less is not treated as a “rental activity” under those regulations. If the owner also materially participates in running it, the losses can be treated as non-passive.
Much of the loss comes from depreciation, and depreciation is where cost segregation comes in. A residential building is normally depreciated over 27.5 years. A cost segregation study identifies the parts of the property that may qualify for much shorter lives, depending on their nature and use: five-year property such as appliances, furnishings and certain finishes and fixtures, and fifteen-year land improvements such as pools, hardscape, outdoor lighting and landscaping. Under the 2025 tax law, property acquired after January 19, 2025 is again eligible for 100% bonus depreciation, so those shorter-lived components can often be deducted in the first year.
That combination of a short average stay, material participation and an accelerated depreciation schedule is the whole strategy. Each part can fail on its own.
Where it goes wrong
- The average stay creeps past seven days. Luxury rentals often book differently from typical vacation homes. A ski house may rent for two weeks over the holidays and a month in February. A summer house may go to one family for all of August. A few long bookings can push the average stay above seven days, and when that happens the property is back to being an ordinary rental. The test is annual, and it is arithmetic, so check it before the year ends rather than after.
- The property manager does too much. There are several ways to establish material participation. Two commonly relevant tests are participating for more than 500 hours during the year, or participating for more than 100 hours and at least as much as any other individual. A full-service luxury management company, with concierge, housekeeping, maintenance and guest communication, can easily log more hours than the owner. That is often the right way to run a high-end property, and it can quietly defeat the test. Owners who intend to use this strategy need to decide how the property will be run and keep a real contemporaneous log of their own time.
- Personal use limits the deductions. If the family’s personal use exceeds the greater of 14 days or 10% of the days the home is rented at a fair price, the property is generally treated as a residence and deductions can be limited. What counts as a personal-use day is broader than many owners expect, including use by relatives. For a vacation home the family loves, this is a common way the plan unravels.
- Land is overstated as building. Land is not depreciable, and at the high end it is often most of the value. A $6 million lot-and-house on the East End or in Aspen may be majority land. A study that uses a generic land ratio, or skips the question, overstates depreciable basis at the very start, and every number built on it inherits the error. A good study explains how land was determined and why.
- A percentage stands in for the property. Many low-cost studies assign fixed percentages by property type: this much five-year property, this much fifteen-year. That can work tolerably on a standard rental. Luxury homes are not standard. Custom millwork, integrated audio and smart-home systems, outdoor kitchens, pools and spas, fire features, specialty lighting and extensive landscaping vary enormously from one property to the next. A percentage can miss real value, or claim value that is not there. A component-level study that identifies what is actually in the house, and supports each classification, is the version worth relying on at this price.
- Furnishings are treated as an afterthought. Many luxury STRs are sold furnished or furnished right after closing, sometimes for six figures. Whether those items conveyed with the purchase or were bought separately affects how they are handled. Keep the inventory and the invoices.
- The exit is not planned. Accelerated depreciation changes the timing of deductions, and it can affect the tax consequences of a later sale. That does not make the strategy a bad one. It means owners should model the exit, whether a sale or a 1031 exchange, as carefully as the first-year deduction.
- The state tax return tells a different story. Several states, including New York and California, do not follow federal bonus depreciation. The federal benefit can be substantial while the state benefit is much smaller, and owners should model both.
- The deduction runs into the excess business loss limit. Even when the losses are non-passive, federal law caps how much net business loss an individual can deduct against wages, investment income and other non-business income in a single year. Anything above that cap carries forward as a net operating loss rather than disappearing, but it will not arrive in year one. For a high earner expecting a large first-year offset, this is often the surprise. The cap is indexed annually, so model it with your advisor before counting on the full deduction.
Getting it right
None of these problems are exotic. They share one cause: treating the strategy as a product to buy rather than a set of facts to establish. The owners who benefit most keep usage and hours logs, choose a management structure with the participation test in mind, and commission a study that reflects the property they actually own.
That last part has become far more accessible. A detailed study used to mean scheduling an engineer’s visit and waiting weeks for a report. A newer generation of providers now works remotely from the owner’s documents, photographs, public property records and construction cost data. Cost Seg Smart, for example, builds component-level cost segregation studies for short-term rentals this way and reconciles every component back to the property’s basis, so the owner’s CPA can see how each number was reached.
Whichever provider you use, ask three questions before you sign. How was land determined? Is the study built from this property’s components or from a percentage? Will my CPA be able to follow the reconciliation? The answers will tell you more than the price.
This article is for general information and is not tax advice. Short-term rental rules depend on specific facts; consult a qualified tax advisor before acting.
Jamie Melgar writes about finance, tax and lifestyle. When she is not writing, she is usually surfing.
