How the Short-Term Rental Loophole Turns a Passive Property into a Powerful Tax Deduction

Written byAlex McGowin
Discover how the short-term rental loophole can unlock trapped rental losses for US expats. Real Costa Rica case study reveals strategies to turn passive properties into powerful tax deductions.

Picture this: You've just purchased your dream vacation rental in Costa Rica for $700,000. You're excited about the rental income potential, but your accountant delivers crushing news: "You won't be able to write off any of it."

This exact scenario played out in a recent client consultation, where a couple discovered their Costa Rican property was structured in a way that could drastically limit their tax planning options - but we able to show them a lesser-known strategy that could save them tens of thousands.

You see, most real estate investors assume their rental losses are off-limits for tax purposes, especially if they have W-2 income or earn too much to benefit from the usual exceptions. But there's a powerful opportunity tucked away in the tax code that can flip that outcome entirely: the short-term rental rule.

By structuring a rental correctly, you can turn passive income into active income, unlock losses against your ordinary income, and bypass the real estate professional hurdles entirely.

Why Most Expat Rental Losses Get Trapped

By default, the IRS treats rental properties as passive activities. For expats, this creates a double burden:

Passive Activity Loss Limitation: You can't use rental losses to offset non-passive income like wages or business profits.

Net Investment Income Tax (NIIT): If your income exceeds certain thresholds, you'll pay an additional 3.8% tax on rental profits.

There is a limited exception: if you actively participate in the rental and your income is under $150,000, you can deduct up to $25,000 in losses. But this phases out rapidly above $100,000 and vanishes altogether for higher earners.

As you can see in the consultation video, this can be pretty disheartening news.

Why the Real Estate Professional Route Fails Most Expats

To escape passive loss limitations, many aim to qualify as real estate professionals. But the bar is impossibly high for most expats:

  • 750 hours per year spent in real estate activities
  • More than 50% of your total working time in real estate
  • Material participation in each property (or proper aggregation)

For expats with full-time jobs or those who hire property managers, it's simply not practical. As our Costa Rica client noted about her husband: "That's not gonna work for sure" due to his partnership income from his primary business.

The Short-Term Rental Game-Changer

Here's where it gets interesting. There's a special carve-out that completely changes the rules: if your average guest stay is 7 days or less, the IRS doesn't classify it as a rental activity at all.

Instead, it becomes a business activity. Meet the material participation test, and you can deduct losses against any type of income - wages, self-employment, investment income, everything.

Requirements:

  • Average stays of 7 days or fewer (or 30 days with substantial services)
  • Material participation (typically 500+ hours, or 100+ hours if you do more than anyone else)

The biggest advantage? You don't need real estate professional status. Just meet the participation threshold.

The Hidden Trap That Destroys the Strategy

During our consultation, we uncovered the critical flaw in most expat short-term rental plans: personal use limitations.

Under Section 280A, if you use the property personally for more than 14 days OR 10% of rental days (whichever is greater), the property becomes a "residence" and losses get capped at rental income.

Real Example from the Consultation:

  • Property rented 80 days per year
  • Personal use: 30 days
  • 10% of 80 rental days = 8 days
  • Since 30 > 14 days, the loss limitation kicks in

As we explained to the client: "If you spend more than a a few weeks [in the property], basically, then you're gonna get tripped up by this personal use rule."

This most often occurs even when you're trying to avoid it when you're staying the the house while renovating the new property, then trying to adhere to the rule while renting it out later in the year.

Common Pitfalls That Trip Up Expats

1. Hiring a Property Manager If someone else logs more hours than you do, you fail the participation test. Here's how our client mitigated this exact concern: "I have a property manager down here, but with all the construction and stuff, I think I can document that [I'm doing more]."

2. Personal Use Miscalculation Many expats underestimate how personal use days accumulate. Even working on the property counts as personal use unless it's solely for rental purposes.

3. Entity Structure Problems Our Costa Rica clients had their property in a foreign corporation (SA), which created additional complications. Foreign corporations are treated as separate taxpayers, blocking flow-through of losses and creating anti-deferral rule issues.

A Success Strategy: Costa Rica Done Right

Here's how to structure the type of scenario in our consultation correctly:

Step 1: Fix the Entity Structure Convert from Costa Rican SA (corporation) to SRL (LLC equivalent) and elect flow-through treatment with the IRS. This single step can save thousands in compliance costs and unlock better tax treatment.

Step 2: Document Everything Track time meticulously. As we advised: "Break out [work activities] on different days so you can show the IRS... these days for rental, these days weren't."

Step 3: Manage Personal Use Strategically If you rent out 300 days per year, you can use the property personally for up to 30 days. Plan accordingly.

Step 4: Coordinate with Local Tax Rules Don't forget Costa Rican compliance. You'll need monthly VAT filings and electronic invoice system setup.

When Losses Get "Unlocked"

Even if personal use rules limit current deductions, losses aren't lost forever. They carry forward and can be unleashed when:

  • You have future rental income
  • You sell the property
  • You acquire additional rentals that don't trigger personal use limits

As we explained: "Let's say you meet the real estate professional rules, but the personal use day rules limited you for three years... in year four... we can unlock all of the prior year losses."

One strategic option? "For one of these months I'm gonna go rent a house down the street, you know, and stay there just to unlock $50,000 of losses."

Before we close out, let's look at two more recent scenarios we've seen.

A Real-World Example: Turning a Costa Rica Getaway into a Tax Shield

Take a U.S.-based couple who purchases a $700,000 vacation rental in Costa Rica. They rent it out for 180 days a year, with an average stay of 3 days. They self-manage the listing, coordinate cleaners, respond to guest issues, and track 600 hours of involvement. They personally use it for just 10 days.

Because they:

  • Keep average stays under 7 days
  • Meet the material participation test
  • Keep personal use under the IRS thresholds

...they can deduct the rental losses against their W-2 income, even though the property is located abroad and not eligible for bonus depreciation.

A Cautionary Scenario: When Personal Use Breaks the Rule

Now imagine a different couple who also owns a short-term rental. They only rent it out for 80 days per year and use it personally for 12 days.

Because 10% of the rental days is just 8 days, and their personal use exceeds that, the property is considered a residence under Section 280A. As a result:

  • They are no longer allowed to deduct a loss
  • Their expenses are limited to the amount of rental income
  • Any excess loss is disallowed

Even if they met the material participation test, the personal use limitation prevents them from claiming a deduction beyond the rental income earned.

The Bottom Line for Expats

The short-term rental exception offers one of the few ways high-income expats can turn foreign rental properties into legitimate tax shields. But success requires:

  • You self-manage or tightly control the work
  • You minimize personal use to stay under the Section 280A limits
  • You track your time and rental activity carefully to ensure you meet participation thresholds
  • Professional guidance to navigate both US and local tax requirements

As our Costa Rica consultation revealed, the difference between tax disaster and tax optimization often comes down to understanding these interconnected rules and structuring everything correctly from the start.

With the right setup, the short-term rental rule offers a clean workaround to the passive activity limits - no real estate professional status required.


Thanks for subscribing! 🎉

LinkedInFacebookYouTubeTikTok

Services

Expat Tax ServicesInternational Corporate Tax ConsultationFirm to Firm Support

Contact

251.232.7115alex.mcgowin@mcgowintax.comMobile, AL

© McGowin Tax 2025 | Designed by AVO Dynamics