Short-Term Vacation Rentals and Material Participation – Houston Tax Attorneys

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.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Recent Reviews

COVID-19 Extended Tax Deadlines Longer Than Many Realized – Houston Tax Attorneys

Taxpayers have various tax filing deadlines throughout the year. Missing one can trigger penalties, interest charges, and collection actions.

When there is a major disaster, the IRS typically grants short extensions to give affected taxpayers breathing room. During the COVID-19 pandemic, the IRS issued notices extending various tax deadlines by a few months. The agency moved the April 15, 2020 deadline to July 15, 2020, for example. Most taxpayers and tax advisors assumed these specific notices defined the full extent of available relief.

What if the law actually provided a much longer extension than the IRS provided? A recent case from the Court of Federal Claims says that is exactly what happened. In Kwong v. United States, No. 23-271T, (Fed. Cl. Nov. 25, 2025), the court held that statutory relief extended certain tax deadlines until July 2023—years beyond what the IRS had publicly announced in its COVID-19 disaster declarations.

Facts & Procedural History

The taxpayer owned and managed real estate through his business. In 2005, he bought out his co-owners and became the sole owner. As part of that transaction, he refinanced the business property. On advice from his tax attorney and accountant, he claimed a loss of over $2.3 million on his 2005 tax return. He carried that loss forward to subsequent years, including 2007, 2010, and 2011.

The IRS audited the tax return for 2005 and disallowed the loss in 2012. This resulted in additional tax liabilities for the years to which he had applied the loss. The IRS simultaneously assessed delinquency penalties for those tax years in April 2012 for the 2007 tax period and later for 2010 and 2011. The taxpayer also had penalties for tax years 2015 and 2016 related to underwithholding taxes throughout those years.

In 2020, the taxpayer filed penalty abatement requests seeking refunds of the penalties he had paid for each of the 2007, 2010, 2011, 2015, and 2016 tax years. The IRS issued notices of disallowance for his 2007, 2010, and 2011 claims in September and October 2020. The taxpayer filed his complaint to start the tax litigation in February 2023 in the U.S. Court of Federal Claims seeking refunds of the penalties for all five tax years.

The government moved for summary judgment. It argued that the claims for 2007, 2010, and 2011 were untimely because the taxpayer filed suit more than two years after the IRS denied his claims. The government also argued that the IRS had correctly assessed penalties for 2015 and 2016. The taxpayer responded that his suit was timely because of statutory extensions under COVID-19 emergency relief legislation. This defense triggered extensive briefing on whether and how the pandemic extended his deadline to file suit.

The Two-Year Deadline for Tax Refund Suits

Section 6532 of the tax code provides strict time limits for filing suit to recover taxes or penalties. It generally says that a taxpayer cannot file suit “after the expiration of 2 years from the date of mailing . . . of the disallowance of the part of the claim to which the suit or proceeding relates.” This two-year window begins when the IRS formally denies a refund claim. Miss that deadline and the courthouse doors close.

The Federal Circuit has long held that Section 6532’s deadline is jurisdictional. This means courts lack power to hear cases filed after the two-year period expires. The jurisdictional nature of the deadline prevents equitable tolling—the doctrine that allows courts to extend deadlines when extraordinary circumstances beyond a party’s control prevent timely filing. Courts cannot create extensions based on fairness or hardship.

However, jurisdictional deadlines can still be extended by statute. Section 6532 itself recognizes this possibility. The statute provides that the two-year period “shall be extended for such period as may be agreed upon in writing between the taxpayer and the Secretary.” Congress can likewise extend these deadlines through legislation addressing specific circumstances.

Section 7508A: The Disaster Relief Statute

Section 7508A gives the Secretary of the Treasury authority to postpone tax-related deadlines during disasters.

Congress enacted Section 7508A to address natural disasters that temporarily disrupt taxpayers’ ability to meet their obligations. The typical scenario involves hurricanes, floods, or wildfires. These events damage infrastructure, displace populations, and make compliance impossible for defined periods. The statute typically operates for short time periods. A hurricane makes landfall, causes destruction over several days, and the affected area begins recovery. The IRS issues a notice extending deadlines by a few months to give taxpayers time to get back on their feet.

The statute allows the Secretary to “specify a period of up to 1 year that may be disregarded” during a taxpayer’s deadline to file returns, pay taxes, or bring suit for refunds. This discretionary authority under subsection (a) lets the Secretary respond flexibly to emergencies.

The statute also includes an automatic extension provision in subsection (d). This mandatory extension applies without any action by the Secretary. Under the version in effect before November 2021, the automatic extension ran from “the earliest incident date specified in the declaration” to “the date which is 60 days after the latest incident date so specified.” Unlike the discretionary extension under subsection (a), the mandatory extension under subsection (d) contained no express time limit in the pre-2021 version.

The mandatory extension in subsection (d) historically operated in tandem with the discretionary extension. For a typical disaster, the mandatory 60-day extension might run from the disaster’s start through 60 days after its end. This might total three or four months. If taxpayers needed more time, the Secretary could exercise discretionary authority under subsection (a) to extend deadlines up to a year. This two-tier system worked well for localized, short-term emergencies. No one anticipated how it would function during a multi-year national pandemic.

How the Statute Changed in 2021

Congress amended Section 7508A in November 2021. Understanding which version applies requires careful attention to effective dates and statutory language. This proved to be the key issue in Kwong.

The original 2019 version of subsection (d) stated that the mandatory extension period ran from “the earliest incident date specified in the declaration” to “the date which is 60 days after the latest incident date so specified.” This language tied the extension’s length directly to the disaster declaration itself. If the declaration said the disaster lasted from Date A to Date B, the mandatory extension ran until 60 days after Date B. The statute imposed no cap on how long that period could last.

In November 2021, Congress amended subsection (d). The new version changed the end of the extension period from “the date which is 60 days after the latest incident date so specified” to “the date which is 60 days after the later of such earliest incident date . . . or the date such declaration was issued.” This amendment effectively capped the mandatory extension at 60 days maximum. The extension would end 60 days after either the disaster’s start or the declaration’s issuance, whichever came later.

This change matters in this case. Under the 2019 version, a disaster that lasted three years would trigger an extension that lasted three years plus 60 days. Under the 2021 version, that same disaster would trigger only a 60-day extension. The question in this case is which version applies to COVID-19?

The answer depends on when the disaster was declared. The November 2021 amendment applied only “to federally declared disasters declared after the date of enactment of this Act.” The COVID-19 disaster was declared in early 2020. Therefore, the 2019 version of Section 7508A governs COVID-19 cases. The government initially argued that the 2021 amendment should apply retroactively to COVID-19. Only after the court pressed the issue did the government concede that the amendment’s effective date provision barred retroactive application.

When Did the COVID-19 Emergency Begin and End?

On March 13, 2020, President Trump declared a nationwide emergency. On March 22, 2020, he declared California, where this taxpayer resided, a major disaster area “beginning on January 20, 2020, and continuing” due to pandemic conditions. The Federal Emergency Management Agency coordinated the response.

That phrase “beginning on January 20, 2020, and continuing” became the linchpin of the Kwong decision. The declaration established January 20, 2020 as the “earliest incident date.” But what was the “latest incident date”? The declaration said the emergency was “continuing.” This suggested no fixed end date at the time of issuance.

The pandemic emergency declaration remained in effect for over three years. On February 10, 2023, the government amended the declaration to close the incident period effective May 11, 2023. This amendment established May 11, 2023 as the “latest incident date” for purposes of Section 7508A.

Under the plain language of the 2019 statute, the mandatory extension ran from January 20, 2020 through July 10, 2023. The latter date represents 60 days after May 11, 2023. This created an extension period of roughly three and a half years. No one anticipated such a duration when Congress drafted Section 7508A.

Does “Continuing” Mean There Was No Specified End Date?

The government argued that because the initial declaration said “continuing” rather than specifying an end date, only January 20, 2020 qualified as a date “so specified” under the statute. According to this reading, both the earliest and latest incident dates were January 20, 2020. This would yield only a 60-day extension from that single date.

The Kwong court rejected this argument. The word “continuing” has meaning. If the declaration was meant to cover only January 20, 2020, it would not have added “and continuing.” The government’s choice to maintain the disaster declaration beyond January 20, 2020 demonstrated that the emergency period extended far beyond that initial date. The government kept the declaration in effect for more than three years. This active maintenance of the declaration showed that the emergency continued throughout that period.

The government relied on Abdo v. Commissioner, 162 T.C. 148 (2024), for support. In Abdo, the Tax Court addressed whether COVID-19 extended certain filing deadlines. The court held that taxpayers who filed within 60 days of January 20, 2020 had filed timely. But Abdo did not address whether the extension could last longer than 60 days. The taxpayers there had filed within the initial 60-day window. The Tax Court explicitly noted: “We need not, and therefore do not, express a view on what the outer limits of the extension period may be where a declaration omits an ending date or is extended.”

The Kwong court thus faced a question Abdo left open. The court concluded that the declaration’s use of “continuing” meant the emergency period extended as long as the declaration remained in effect. When the government amended the declaration in February 2023 to close the incident period on May 11, 2023, that date became the “latest incident date” under the statute. The mandatory extension therefore ran until 60 days after that date.

How This Applied to the Taxpayer’s Refund Suit

The taxpayer’s deadline to file suit began when the IRS denied his refund claims in September and October 2020. Under normal circumstances, he would have had until September or October 2022 to file suit. This represents the two-year period from the denial date under Section 6532. He filed in February 2023—several months after that normal deadline expired.

But the COVID-19 mandatory extension under Section 7508A lasted until July 10, 2023. Section 7508A allows affected taxpayers to “disregard” deadlines that fall within the extension period. The taxpayer’s September and October 2020 denial notices triggered deadlines that would normally expire in September and October 2022. Those expiration dates fell within the January 2020 to July 2023 extension period. Therefore, the taxpayer could disregard those deadlines until the extension period ended.

When the July 2023 extension period ended, the taxpayer’s two-year clock to file suit would have started running again. Because he filed in February 2023—well before July 2023—his suit was timely. This analysis applies regardless of whether we characterize Section 7508A as providing tolling or a postponement period. Tolling pauses the clock while postponement moves the deadline. Either characterization leads to the same result here.

The court granted summary judgment in the taxpayer’s favor on the timeliness issue for tax years 2007, 2010, and 2011. This means his refund claims for those years can proceed to address their merits. Whether he ultimately wins those refunds depends on whether the IRS properly assessed the underlying penalties. The court did not reach that question in its summary judgment decision. The parties will need to litigate the substantive penalty issues at trial or through further proceedings.

The Takeaway

The Kwong decision explains that the COVID-19 emergency extended tax deadlines far longer than the IRS’s public guidance suggested. The mandatory extension under Section 7508A’s pre-2021 version ran from January 20, 2020 through July 10, 2023. This extension applied automatically to any taxpayer affected by the declared disaster. It operated regardless of whether the IRS issued specific guidance for particular situations. The practical impact remains viable for some taxpayers even to today. By late 2025, a taxpayer seeking to invoke the July 2023 extension would need to have had a deadline fall during the COVID-19 period. They would then need to have acted quickly enough after July 2023 to file claims while their own limitations periods remained open. Most such claims have now expired through the passage of time, but those who filed during this time, even if late, may benefit. This may preserve claims the government thought time-barred.