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Qualifying as a real estate professional is an attractive opportunity for many real estate investors. The designation offers significant tax benefits, often enabling full-time real estate operators to save tens of thousands of dollars on their annual taxes.
But securing real estate professional status takes much more than just checking a box on your tax return. It’s a heavily litigated area of the tax code, and if you want to get real estate professional status, you need to take a very deliberate approach with the guidance of qualified tax advisors.
In this guide, we’ll share the steps involved in securing real estate professional status. But you should be aware that qualifying for real estate professional status means nothing in itself. What’s important is that you materially participate in your rentals and you’re able to substantiate this tax position with a comprehensive bank of evidence that will stand up to scrutiny in Tax Court.
Provided you take the right approach, there’s no reason to be intimidated. If you qualify, electing to be taxed as a real estate professional represents a fantastic opportunity to lower your tax liability and accelerate your wealth accumulation journey.
What follows is a top-level overview of how to get professional real estate professional status. For a deeper dive, download our 12,000+ word Guide to Qualifying as a Real Estate Professional or contact one of our tax advisors to learn more.
What is Real Estate Professional Status?
Before you start planning the steps you need to take to qualify as a real estate professional, it’s important to understand exactly what real estate professional status is and who it’s designed for.
Real estate professional status, also referred to as REPS, is a tax designation designed to allow individuals who manage their rental real estate holdings full-time to have the income and losses from these activities be treated as non-passive.
Income from real estate investment activities is considered “per se” passive by the IRS. That means that the losses your real estate portfolio produces via depreciation can only be used to offset other passive income – not non-passive income such as a W-2 job.
By securing real estate professional status, individuals who actively operate a rental real estate portfolio can overcome that presumption. Instead, their income and losses from real estate will be characterized as non-passive––since, in the eyes of the IRS, they are actively working on their real estate business as their primary job.
How to Qualify as a Real Estate Professional
There’s no doubt that being taxed as a real estate professional is an attractive designation for many who invest in rental real estate, but the unfortunate reality is that not everyone qualifies. There are many tax rules for real estate professionals that you should be aware of.
First off, if you hold a full-time job outside of your real estate activities, it’s likely you don’t qualify. If you hold a part-time job, it’s possible but still difficult. There are plenty of Tax Court precedents that back these statements up.
In truth, real estate professional status is a pretty descriptive name. The status is primarily designed as a carve-out for individuals who are full-time real estate professionals. That means they actively work in real estate and manage their real estate portfolio as their primary “job”.
To prove that to the IRS, there are a couple of tests you have to pass, and if you’re audited, you’ll want to have bulletproof documentation that supports your stance.
The major test you must satisfy to get real estate professional status is the material participation test. To qualify as a real estate professional, over half of the personal services you undertake during the year must be spent materially participating in a qualified real estate trade or business.
This concept of material participation is extremely important. Satisfying the requirements of material participation requires real estate investors to meet one of the seven criteria the IRS outlines for material participation.
These tests can be relatively complex and we encourage you to contact a qualified CPA to understand if you satisfy at least one of them. You can view all seven material participation tests here.
Most people who qualify as real estate professionals satisfy the first test: participating in the activity for more than 500 hours in the tax year. Those hours generally also count towards the second test to qualify as a real estate professional, which is that you must spend over 750 hours working in a real estate trade or business.
However, getting real estate professional status isn’t just as simple as saying you spent a certain amount of time working on your real estate business. To successfully claim and defend this tax position, you need to collect evidence that substantiates your position.
How to Substantiate Your Position As a Real Estate Professional
If you elect to be taxed as a real estate professional, your chances of becoming audited increase. But provided you have sufficient evidence to document your stance, there’s nothing to worry about. So what does that evidence look like? Here’s an overview.
Its suggested real estate professionals maintain comprehensive time logs of the hours they logged working on their real estate business throughout the year. These time logs should be kept on an ongoing basis, and you need more than just diary entries that summarize your time: you need proof.
What does that proof look like? It varies: it could be emails, meeting minutes, receipts, and more. Keep records of everything you think could be relevant––if you’re audited, the burden of proof is on you, not the IRS.
You should also be aware that not every hour you spend managing your real estate portfolio counts toward the 750 hours needed to claim real estate professional status. Some activities, including time spent on investor activities, education, and travel, do not count toward meeting the criteria. Broadly speaking, only activities directly related to the management of your rental properties count: working on improvements, maintenance, or dealing with tenants.
Partner with Hall CPA: An Accounting Firm Built for Real Estate Investors
We’re not trying to dissuade anyone from getting real estate professional status. But we do believe it’s important for real estate investors to know exactly what they’re signing up for when they choose to go down the path of securing real estate professional status.
The level of complexity involved in qualifying as a real estate professional makes it important for real estate investors to seek guidance from experienced real estate tax professionals. At Hall CPA, our tax advisors specialize in real estate tax strategy and have extensive experience guiding investors through the process of getting real estate professional status.
If you’re interested in learning more about qualifying as a real estate professional, we encourage you to contact us today.