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If you’re a real estate investor, you’re likely aware of some of the significant tax benefits that come with owning rental real estate.
Used together, strategies like cost segregation, depreciation, and 1031 exchanges can dramatically impact your wealth, reducing your tax liability and enhancing your ability to invest in more properties.
While these are all valuable tax strategies, there’s another advanced tax strategy that offers even more significant benefits: real estate professional status. As a real estate professional, your passive losses are deductible against your ordinary income.
Becoming a real estate professional can have a huge impact on your taxes. Because of this, it’s natural to wonder how you can become a real estate professional yourself.
You’re not alone. As a specialized real estate accounting firm, it’s a question we hear from clients all the time: “how do I become a real estate professional?”
Today, we’re sharing an introductory overview of the process. We’ll explore the types of investors that are eligible for this status, share some of the benefits on offer, and walk you through the basic steps that go into becoming a real estate professional.
But first, let’s start with a definition of exactly what Real Estate Professional Status (REPS) is (and isn’t).
What is Real Estate Professional Status?
Per IRC Sec. 469, all real estate rental activities are considered to be “per se” passive. That means that any losses created by your rental real estate (through depreciation), are treated as passive losses and can therefore only be deducted against passive income.
What does that mean in practical terms? You can only use the losses from your real estate to offset income you earned passively, like rental income and income from other passive activities. It cannot be used to offset the non-passive income you earn through your W-2 job or business activities.
Unless you have real estate professional status.
Real Estate Professional Status is a designation that you elect on your tax return. To be considered a real estate professional, there are a couple of conditions that you must meet, which we’ll get into below.
To be a Real Estate Professional, you don’t have to be a broker, an agent, a contractor, or work in any other type of job that’s related to real estate. There’s no training course, diploma, or license––it’s simply a tax treatment.
Who Can Be a Real Estate Professional?
Because of the tax benefits that being a real estate professional unlocks, it’s a designation that many real estate investors are attracted to. However, the reality is that it’s difficult to qualify as a real estate professional.
If your tax advisor is telling you otherwise, we suggest you read our 12,000+ word guide to qualifying as a real estate professional––it might save you a major headache down the road.
Don’t have time to read that right now? Here’s a quick overview of who can be a real estate professional.
First things first. If you have a full-time job, it’s near impossible to qualify as a real estate professional. We’ve yet to see a Tax Court case where a taxpayer has been able to effectively support that position and win their case.
If you’re working a part-time job, it’s possible, provided you keep great records that detail the time you spent on your real estate.
Really though, real estate professional status is designed for people who are, well, real estate professionals. That means managing your portfolio of rental properties is your primary job. To justify that, there are a couple of tests you must satisfy.
How Do You Become a Real Estate Professional?
In itself, becoming a real estate professional doesn’t mean anything: it simply lays the groundwork for your losses to be characterized as non-passive.
To have these losses be treated as non-passive, you must satisfy two criteria:
- Over 50% of the personal services you performed in all businesses during the year must be performed in a real estate business in which you materially participate
- You must spend over 750 hours working in a real trade or business
Did you notice the words “materially participate” are in bold?
There’s a reason for that: to materially participate (and achieve this tax designation), you must pass one of seven material participation tests specified by the IRS. We’re not going to get into these tests in this primer, but you can view them on the IRS website here. For most real estate investors, the test most often used is the 500 hour participation rule.
What do these hours have to be spent on? Again, there are strict rules, and it’s vital you keep a contemporaneous record of the time you spent, backed by proof like receipts and emails.
Here are some activities that do count:
- Showing the property to prospective tenants
- Processing tenant applications and leases
- Cleaning after tenant move-out
- Working on repairs or improvements
- Communicating with tenants
And some activities that don’t count:
- Investor hours
- Education and research hours
- Travel time
As you can see, you practically need to self-manage your properties to be considered a real estate professional. If you employ a property management firm, it’s unlikely you’ll satisfy the requirements. To be a real estate professional, you need the time and willingness to get your hands dirty working in and on your rental properties.
Work with a Specialized Real Estate Accounting Firm
In case this isn’t clear by now, becoming a real estate professional isn’t a walk in the park.
It’s certainly not an area where you should take shortcuts. The IRS is not afraid to litigate real estate professional status. If you pursue this strategy, you should expect to be audited.
However, with the guidance of an accounting firm that truly understands Real Estate Professional Status, there’s no reason you cannot avail yourself of this tax strategy. For those that qualify, the potential tax benefits are enormous: enabling you to write off tens or hundreds of thousands of dollars in non-passive income each year.
If you need support navigating the accounting requirements of your real estate activities, Hall CPA is here to help. Our advisors focus exclusively on the real estate industry, working with thousands of investors all over the country to build more efficient tax strategies that accelerate your wealth accumulation journey.
Interested in learning more? Contact us today.