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Last Updated : July 8, 2024

How High-Income Earners Can Benefit by Qualifying for Real Estate Professional Status

Benefits of real estate professional status for high-income earners

If you hang around real estate investors long enough, you’ll eventually learn about the benefits of real estate professional status. Qualifying for real estate professional status, allows you to use all of the losses generated from your rental investments.

Rental real estate generally produces tax losses even when there is positive cash flow and NOI. This is thanks to depreciation, a non-cash expense that is meant to track the deterioration of your asset over time.

Annual depreciation expense on most rentals is calculated by subtracting the “land value” from the purchase price and then dividing by 27.5 years.

For example, a rental can generate $20k in revenue, $15k in expenses, and $6k in annual depreciation. In this example, the landlord would have $5,000 of positive NOI but report a $1,000 tax loss after accounting for depreciation.

As a result, all of the NOI is sheltered from tax, and there’s an additional $1,000 tax loss that can potentially be used.

But how do we know if the $1,000 tax loss can be used?

Passive versus Non-Passive Losses

Under IRC Sec. 469, losses from rental real estate are deemed “passive” unless you qualify as a real estate professional.

Essentially, these rules create two buckets of income:

  1. Passive: All income in the passive bucket can be offset by losses in the passive bucket.
  2. Non-passive: All income in the non-passive bucket can be offset by losses in the non-passive bucket.

If you can’t qualify as a real estate professional, your losses from your rental real estate will be passive.

If you don’t have passive income, the losses will be suspended and carried forward.

How to qualify as a real estate professional

To reap the benefits of real estate professional status, you must meet two quantitative tests:

  1. Spend 750 hours in a real property trade or business
  2. Work more in real property trades or businesses than you do anywhere else

You must also meet one of the seven material participation tests, which I explain more thoroughly in this article.

The material participation tests are evaluated on a property-by-property basis unless you make a “grouping” election under Regs. 1.469-9(g).

It’s Not Simple, and It’s Frequently Audited

Obtaining real estate professional status tax benefits is not simple.

Taxpayers make the critical mistake of claiming REPS when they work full-time jobs because the tax benefits are too appealing.

Sec. 469 is one of the most frequented audited areas in our experience representing clients.

Often, clients will keep a time log of their activities and include time spent in investor, education, research, and travel activities – none of which count for real estate professional status.

But if you can qualify, your losses from rental real estate can be used to offset your W2 and business income. You can accelerate depreciation via cost segregation studies to increase the losses you can claim.

So how does a high-income earner qualify as a real estate professional?

Strategy #1 – Reduce day job to part-time hours

In certain situations, you may be able to have full-time pay with part-time hours.

Physicians and pilots that we work with often have the ability to work flexible schedules.

In their off time, they work on their rental properties, and they can log enough hours to exceed the actual time spent at their day job.

Important point: you must also log your time spent at your day job. If audited and taken to tax court, you will want to produce a time log showing you clearly spent more time in real estate than your day job.

Strategy #2 – Have your spouse qualify as REPS

Another strategy is to have a stay-at-home spouse qualify as a real estate professional.

Sometimes, our high-earning clients want to benefit from REPS. However, they can’t possibly meet the “more time in real estate than anywhere else” because they work full-time at their day jobs.

In such cases, we can look to your spouse to qualify as a REP.

If your spouse meets the 750-hour test and more time in real estate than anywhere else, and also materially participates in the rentals, then rental losses can be used to offset the high-income spouse’s W2.

The risk with this strategy is when the stay-at-home spouse is not interested in managing rental properties. It’s important not to “force” REPS by stretching the truth as it often comes out under IRS audit.

Strategy #3 – Buy and manage short-term rentals

If you buy short-term rentals where the average period of customer use is seven days or less, you don’t have to qualify as a real estate professional to deduct the losses from your rental real estate.

This workaround exists because short-term rentals are not “rental activities” under IRC Sec. 469.

Real estate professional status applies only to “rental activities.”

As a result, a high-income earner with a full-time W2 job can buy STRs, cost segregate them, and use the rental losses to offset their W2 job income without qualifying as a real estate professional.

But remember: you must always materially participate.

If you’re interested in partnering with us to guide you through REPS, fill out this form.