Can a Short-Term Rental Really Offset W-2 Income?

When you're staring down a seven-figure income year, the tax bill hits hard. It's no surprise that many high-earning business owners start exploring strategies to reduce their tax burden. But does this strategy actually work the way most people think it does?

I recently came across a conversation that perfectly illustrates both the appeal and the potential pitfalls of this approach. A business owner couple projected to hit $1 million in combined income asked a straightforward question:

Should they buy a short-term rental and use accelerated depreciation to offset their income?

The response they received is worth breaking down because it reveals some critical truths that many CPAs don't emphasize enough upfront.

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The Passive Activity Loss Problem

Rental income is generally classified as passive income, and passive losses can only offset passive income, not your active business or W-2 income.

This is where the short-term rental strategy often falls apart for busy business owners. If you're running a company that's generating $1 million annually, you probably don't have hundreds of hours to spare managing rental properties.

And if you hire a property manager and automate everything (which is what most people do), you've essentially killed your argument for active participation.

There is a special allowance that lets you deduct up to $25,000 in passive rental losses against ordinary income, but this phases out completely once your modified adjusted gross income exceeds $150,000. So if you're making $1 million, forget about it.

The Real Estate Professional Status Workaround

The path to deducting rental losses against your high ordinary income is achieving Real Estate Professional Status (REPS).

This requires:

1. Spending more than 750 hours per year in real estate activities

2. Having more than half of your working hours be in real estate trades or businesses

3. Materially participating in your rental activities (typically 500+ hours per property, or meeting one of several other tests)

The responder in this conversation qualified for REPS because they're "semi-retired" and real estate is mostly all they do. But for a couple running businesses that generate $1 million in income? That's going to be nearly impossible unless one spouse transitions away from the business to focus exclusively on real estate.

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Accelerated Depreciation to Offset High Income

Cost Segregation is where things get interesting, and where many people misunderstand what's actually available.

Standard rental property depreciation spreads the building's value (excluding land) over 27.5 years for residential property. On a $925,000 property (the example given), that's about $33,000 per year in depreciation deductions.

Accelerated depreciation through cost segregation studies can identify components of your property that qualify for shorter useful lives... things like:

• Land improvements (pools, parking areas, landscaping)

• Personal property (appliances, furniture, fixtures)

• Certain building components that can be reclassified

Cost segregation studies typically make financial sense when you have at least $300k in property basis, and they work best when you're doing significant renovations where costs can be easily segregated and categorized at the time of expenditure.

Crunching the Numbers

Let's look at the actual results from a real estate investor who's living this strategy:

• Property purchased: $925,000

• Annual gross revenue: $110,000

• Annual depreciation deduction: $33,000

• Result: Helps reduce taxable income from the property itself, but doesn't create losses to offset other income

This is the reality for most STR investors who don't qualify for REPS. The depreciation is beneficial, but it's primarily offsetting the rental income.

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The Bottom Line for High-Income Earners

If you're making $1 million and hoping to buy a short-term rental to significantly reduce your tax bill, you need to have an honest conversation with your tax advisor about these critical questions:

1. Will you qualify for Real Estate Professional Status?

If not, any losses will be trapped as passive and unusable against your business income.

2. What's the actual depreciation benefit?

A cost segregation study on a $1 million property might accelerate $200,000-$400,000 of the basis, which sounds great, but if it's passive, it doesn't help with your current tax problem.

3. Is the property a good investment on its own merits?

Don't let the tax tail wag the investment dog. If the numbers don't work without the tax benefits, they probably don't work with them either.

Alternatives to Consider

• Retirement plan contributions (SEP-IRA, Solo 401(k), defined benefit plans)

• Cost segregation studies on business property you already own or are acquiring

• Section 179 deductions for business equipment and vehicles

• Qualified Business Income (QBI) deduction optimization

• Strategic entity structuring to maximize available deductions

Accelerated depreciation strategy is powerful, but primarily for those who can legitimately claim Real Estate Professional Status.

Before you buy that vacation rental thinking it'll slash your tax bill, make sure you understand which side of the passive activity loss rules you're actually on.

I’d love to hear your thoughts in the comments or send me a message on X. 

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Remember: Always work with a qualified tax professional who understands your complete financial picture before implementing any tax strategy. What works for one taxpayer may not work for another, and the tax consequences of getting these rules wrong can be significant.