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May 6, 2024 | read

Navigating the Real Estate Professional Tax Status

Brandon Hall

The real estate professional tax status is a powerful tool for high-income real estate investors, potentially bringing their tax bill down significantly. This designation applies to individuals who meet specific requirements set forth by the Internal Revenue Code (IRC) regarding their involvement in real estate businesses during the tax year.

To qualify for real estate professional tax status, an individual must meet two quantitative tests.

This status affords them favorable tax rules when renting out or selling owned property, effectively increasing their advantages in the real estate market.

Understanding and navigating the real estate professional rules can be a complex process, but for those who meet the qualifications, the tax benefits can have a significant impact on their overall taxable income. This, in turn, allows them to confidently invest and grow their real estate ventures while optimizing tax efficiencies.

Real Estate Professional Status

Real estate professional status (REPS) has significant implications for tax benefits in the eyes of the IRS. This designation allows taxpayers involved in the real estate business to take advantage of various tax breaks and deductions that may not be available to regular property owners or investors.

To be considered a real estate professional, an individual must meet certain qualifications. The person claiming REPS must spend at least 750 hours per year participating in “real property trades or business.” This calculation is based on an annual basis, from January 1 to December 31.

Additionally, an investor must spend more time in those real property trades or businesses than they do anywhere else.

It’s important to note that rental activities are considered passive by default, so achieving real estate professional status can provide relief from passive activity loss limitation rules and the 3.8% net income investment tax (NIIT).

Benefits of being classified as a real estate professional include the ability to deduct rental property losses against other sources of income, such as wages or profits from a business.

For example, if a person has a taxable income of $170,000 and real estate losses amounting to $40,000, the combined $40,000 loss could be deducted from the $170,000. As a result, the overall taxable income would be reduced to $130,000 for the tax year. However, if the person does not meet the real estate professional requirements, these losses can only be used to decrease rental income.

Individuals are subjected to income taxes on their earnings at their marginal tax rate, which currently ranges from 10% to 37%. Additionally, they must pay payroll taxes (Social Security and Medicare) on this income, as with any other employment. Qualifying as a real estate professional helps offset one’s marginal rate.

In conclusion, obtaining real estate professional tax status offers a range of financial advantages for those who qualify. The IRC has specific criteria to determine eligibility, and meeting these requirements can result in significant tax savings for those working in the real estate industry.

Navigating the passive activity loss rules is not for the faint of heart. If you need a new CPA, fill out a form.

Requirements for Real Estate Professional Tax Status

750-Hour Rule

To qualify as a real estate professional, an individual must satisfy the 750-hour rule. This criterion states that a taxpayer must work a minimum of 750 hours in a real estate trade or business during the tax year. The 750-hour requirement applies to both active investors and passive investors, and must be met by participating in one of the eleven real property trades or businesses.

More Time In Real Estate than Anywhere Else

A real estate investor qualifying as a real estate professional must also spend more time in real property trades or businesses than they do anywhere else. This often means taxpayers with full-time jobs cannot possibly qualify as a real estate professional because they will be unable to show they spent more time in real estate than their full-time job.

Material Participation Requirement

In addition to the two quantitative tests, a taxpayer must also meet the material participation requirement. Material participation is both qualitative and quantitative. From a qualitative perspective, the participation must be regular, continuous, and substantial. From a quantitative perspective, there are seven material participation tests and the taxpayer must meet one of them.  

Real Property Businesses Requirement

To qualify for real estate professional tax status, a taxpayer must be involved in one or more qualifying real property businesses. Qualifying real property trades or businesses include, but are not limited to:

  • Real estate brokerage
  • Real estate development
  • Rental real estate activities
  • Rental portfolio management

It is important to note that rental activities are considered passive by default, and achieving real estate professional status can help taxpayers avoid the limitations set by passive activity loss rules.

By meeting the requirements for real estate professional tax status, individuals engaged in rental real estate activities, real property development, or managing a rental portfolio can potentially receive significant tax benefits.

Rental Properties and Tax Consequences

Passive vs. Active Income

Rental properties generate rental income, which is classified as either passive or active income for tax purposes. A taxpayer is considered a real estate professional if they qualify under Section 469(c)(7) and materially participate in the rental activity, resulting in the income being treated as nonpassive. Generally, passive income is subject to fewer deductions than active income, affecting real estate investors’ tax liabilities.

Rental Losses and Tax Benefits

Real estate professionals can take advantage of tax benefits arising from their rental properties. Rental losses can be used to offset taxable income, thus reducing total taxable income, providing significant tax savings.

For example, a real estate professional with a total income of $200,000 and net rental losses of $50,000 can use those losses to reduce their total taxable income to $150,000.

In the above example, qualifying as a real estate professional would save the investor $12,000 in taxes (assuming a 24% marginal tax bracket rate).

To qualify as a real estate professional for tax purposes, individuals must meet the specific criteria as outlined above. They must maintain detailed service records, and most taxpayers with just a few rental properties will find it difficult to achieve real estate professional status, especially if they have a full-time job.

It is crucial for real estate professionals to understand the tax consequences of their rental properties and maintain accurate records to fully capitalize on the available tax benefits.

If you’re interested in reading an exhaustive guide on REPS, check out our e-book.

Tax Rules and Regulations

Passive Activity Loss Rules

The passive activity loss (PAL) rules are an essential aspect to consider when dealing with real estate professional tax status. These rules limit the ability to offset net losses from passive activities, such as rental income, against other nonpassive sources of income.

In general, rental activities are considered passive by default.

However, real estate professionals can qualify for relief from these limitations if they meet certain criteria.

Navigating the real estate professional tax status is challenging. If you need a new CPA, fill out a form.

IRC Guidelines and Publications

The IRC has set forth specific guidelines for taxpayers to qualify as real estate professionals. According to the IRC, a taxpayer qualifies as a real estate professional if:

  1. More than one-half of the personal services they perform in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates, and
  2. The taxpayer spends at least 750 hours per year providing personal services in real property trades or businesses in which they materially participate.

Each of these criteria must be met for the taxpayer to be considered a real estate professional.

The investor must also meet one of the seven material participation tests. One such test is considered a “safe harbor” for those who participate in rental real estate activities for more than 500 hours per year or have participated in such activities for more than 500 hours in any five tax years (consecutive or not) during the 10 tax years immediately preceding the tax year in question.

The Internal Revenue Code and relevant IRS publications, such as IRS Publication 925, Passive Activity and At-Risk Rules, provide guidance on the treatment of passive losses and income for real estate professionals.

These tax laws also address the material participation requirements, joint return considerations, and the applicability of the net investment income tax (NIIT) for those who qualify as a real estate professional.

By understanding these guidelines and requirements, real estate professionals can strategically navigate tax rules and regulations to maximize their tax benefits while remaining compliant with the Internal Revenue Service and tax laws.

Recordkeeping for Real Estate Professionals

Time Logs and Tracking

Real estate professionals should maintain a time log to record all the hours spent on their real estate activities. This is crucial to prove their eligibility for the special tax benefits that come with the real estate professional status. 

Creating a detailed time record can help real estate professionals keep track of the hours of services they provide. This can be done by maintaining a daily log and including information such as the date, time, duration, and description of the activities performed.

It is best to be consistent in tracking and updating the time log, ensuring the information provided is accurate and up-to-date.

Documentation for Audits

In the event of an audit, real estate professionals will need to provide sufficient documentation to support their eligibility for the real estate professional tax status.

These documents should include:

  • Contemporaneous daily time reports: These are crucial as they demonstrate the real estate professional’s active and material participation in real property trades. These reports should include clear descriptions of the tasks performed, along with the associated hours and dates.

  • Contracts and agreements: Copies of contracts and agreements related to real estate activities can help verify a real estate professional’s claim for the tax status.

  • Invoices and receipts: These financial documents can support the real estate professional’s claim about their income and expenses related to real property trades.

  • Calendars and appointment books: These can help substantiate the time spent on real estate activities, which is especially useful if a real estate professional does not have a daily time report readily available.

Maintaining organized and accurate records is imperative for real estate professionals seeking tax benefits associated with their status.

Adequate recordkeeping not only makes it easier to claim the benefits but also helps in defending their eligibility during an audit.

Navigating the real estate professional tax status is challenging. If you need a new CPA, fill out a form.

Additional Considerations

Tax Deductions and Strategies

Real estate professionals can take advantage of tax deductions and strategies to reduce their tax burden.

One such method includes leveraging accelerated depreciation to create large first-year tax losses. If the investor meets the real estate professional tax status, the tax loss will offset active income.

Utilizing these types of tax deductions and strategies effectively can yield significant tax advantages for a real estate professional.

Married Couples and Real Estate Professional Status

When a married couple jointly owns a real estate business, they may find it beneficial if at least one of them qualifies as a real estate professional.

If one spouse qualifies as a real estate professional, business income and the other spouse’s W-2 income can be offset by rental losses.

In such scenarios, both individuals should carefully evaluate their work hours and participation in the business to ensure they meet the real estate professional requirements.

Real Estate Syndications

Real estate syndications involve partnerships between multiple investors who pool their resources to invest in properties.

When participating in a real estate syndication, limited partners may not be able to take advantage of the full range of tax deductions and benefits available to real estate professionals.

This is due to their limited role in the syndication activity as well as the material participation requirements.

However, if a taxpayer meets REPS outside of the syndication, the taxpayer can make a grouping election to make the syndication activity non-passive. But note that you must meet the 500 hour material participation test if you go that route.

Real-Life Scenarios and Challenges in Achieving Real Estate Professional Status

Balancing W-2 Job and Real Estate Activities

Many individuals who own real estate investments also hold full-time W-2 jobs. Achieving real estate professional status (REPS) can be challenging when balancing the obligations of both a full-time job and real estate activities.

The IRS routinely audits taxpayers who report W-2 earnings and tax losses from real estate professional status. This is because the IRC requires that more than half of an individual’s personal services in all trades or businesses during the tax year be performed in real property trades or businesses, in which the taxpayer materially participates.

This means that for those with a full-time job must spend more time in a real property trade or business than their W-2 job in order to qualify for REPS.

To demonstrate this, let’s consider Jane, who is a W-2 employee at a property management company and earns a high-income. She also owns multiple rental properties, which bring her passive income.

In order for Jane to qualify for REPS:

  • Jane must spend more time on her own real estate rentals than on her full-time brokerage trade job.
  • Jane must also spend at least 750 hours on her own rentals (or in other real property trades or businesses).
  • Jane must materially participate in her rentals by meeting one of the seven quantitative tests.
  • She should maintain clear records of her time spent on both her professional activities and her real estate dealings.

Even though Jane has a full-time job at a property management company, which is considered a real property trade or business, because Jane does not own at least 5% of the business, she cannot count her W-2 hours as REPS hours. 

So in this case, Jane will not be able to demonstrate that she is a real estate professional.

Navigating the real estate professional tax status is challenging. If you need a new CPA, fill out a form.

Medical Professionals and Real Estate Professional Status

High-income professionals, such as medical practitioners, often seek to diversify their income streams and maximize tax benefits by investing in real estate. However, achieving real estate professional status can be quite challenging for them due to their demanding work schedules.

For example, let’s consider a married couple, Dr. Smith and his spouse. Dr. Smith runs a successful medical practice, while his spouse manages their real estate investments.

In order to qualify for REPS and fully benefit from the tax advantages, they need to meet the following criteria:

  • The spouse managing the real estate investments must spend more than half of their working time on related activities and also meet the 750 hour test.
  • They can both materially participate in the day-to-day management of their properties, such as negotiating leases, managing tenants, and overseeing repairs.
  • Maintaining detailed records of all their real estate activities, including the hours spent and tasks performed, is crucial in proving their eligibility for REPS.

In conclusion, achieving real estate professional status can be beneficial for high-income earners who have a stay-at-home spouse.

Careful planning, active participation, and accurate record-keeping are essential in overcoming these challenges and fully reaping the tax advantages associated with REPS.

Frequently Asked Questions

What activities qualify for real estate professional status?

Real estate professional status is achieved when more than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated.

Activities that count toward the REPS tests include doing repairs and maintenance, negotiating leases, coordinating with tenants, setting rental prices, placing rental ads, screening tenants, doing improvements, purchasing supplies/materials, collecting rents, and evicting tenants.

How do I prove my real estate professional to the IRS?

To prove your real estate professional status to the IRS, you need to maintain proper records of your time spent on real estate activities.

This may include a calendar, appointment book, time log, or a similar method demonstrating your hours spent on real estate tasks.

It is important to be specific, documenting the nature of each activity and the amount of time spent on each.

What does the IRS consider a real estate professional?

The IRS considers a taxpayer to be a real estate professional if they meet two requirements:

1) more than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated, and

2) the taxpayer spent more than 750 hours each year on real estate activities.

What is the IRS Code 469(c)(7)?

IRS Code 469(c)(7) refers to a specific section of the Internal Revenue Code that addresses the tax treatment of a real estate professional’s passive activity losses.

It provides an exception to the general rule that passive activity losses are limited.

If a taxpayer qualifies as a real estate professional, their real estate losses can be used to offset other forms of income, potentially reducing their overall tax liability.

What is Section 469 of the tax code?

Section 469 of the tax code deals with the rules and limitations on passive activity losses and credits.

It generally limits taxpayers’ ability to use passive activity losses to offset non-passive income.

However, there are exceptions for certain taxpayers, including real estate professionals, who can use their real estate losses to offset other income as long as they meet specific criteria.

Is a landlord a real estate professional?

A landlord can qualify as a real estate professional if they meet the two aforementioned requirements:

1) more than half of their personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which they materially participated, and

2) they spent more than 750 hours each year on real estate activities, such as managing their rental properties.