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Qualifying as a real estate professional offers significant tax benefits. This designation enables real estate investors to have the income and losses from their rental real estate properties treated as non-passive income, rather than the default passive characterization. When combined with depreciation, real estate professional status allows investors to save tens of thousands of dollars on taxes.
With such attractive tax benefits, it’s easy to see why so many real estate investors are curious about whether they can qualify as a real estate professional. Fortunately, between IRS rules and established Tax Court precedent, there are a set of specific qualifications that real estate investors must satisfy in order to qualify as a real estate professional.
Before we explore what these qualifications are, we should note that on its own, qualifying as a real estate professional means nothing. Successfully substantiating this position requires detailed documentation, contemporaneous time records, and a well-planned-out tax strategy executed with the support of a specialized real estate tax professional.
At Hall CPA, our tax advisors and CPAs specialize in the real estate industry. We have significant experience helping clients qualify and substantiate their position as real estate professionals. To learn more about our tax planning services, contact us today.
Who Can Qualify as a Real Estate Professional?
Before we explore the specific tests and qualifications that determine who can qualify as a real estate professional, let’s look at the top line.
Real Estate Professional Status (REPS) is a tax designation that is designed as a carve-out for individuals who work in a real property trade or business and manage their own rental properties as their primary professional activity. This means that REPS is typically not a great fit for high-earning W-2 employees or business owners who have a real estate portfolio on the side. If you have a full-time job or business that isn’t a real property trade or business, it’s unlikely you meet the criteria to qualify as a real estate professional.
So who is REPS a good fit for?
Generally, the individuals that routinely qualify and substantiate REPS own a portfolio of long-term rental properties that they actively manage on their own. They don’t use a property management company, instead dealing directly with tenants, managing contractors, and taking responsibility for advertising and filling vacancies. Between all of these activities and more, they spend more time working in their real estate businsses than they do on any other business.
Of course, there are specific tests and thresholds that must be met to qualify as a real estate professional. Let’s take a closer look at exactly what the qualifications for real estate professional status look like.
The IRS Tests to Qualify as a Real Estate Professional
The IRS specifies a series of tests that individuals must satisfy to qualify as a real estate professional. They are:
- Over 50% of all personal services performed in the tax year must be performed in real property trades or business
- More than 750 hours of personal service must be spent in real property trades or businesses
- The taxpayer must materially participate in these activities
You will see these three tests referred to as the 50% test, the 750 hour test, and the material participation test. Let’s take a look beyond the IRS description and explore exactly what you have to do to satisfy the criteria for each test and get real estate professional status.
1. 50% Test
The first test requires that real estate professionals spend over half of their working time working in a real property trade or business. That term, “real property trade or business”, has a specific definition.
There are eleven permitted real property trades and businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade. If you are involved in several of these trades at once, you my be able to group the activities together.
2. 750 Hours Test
In addition to meeting the 50% test, real estate professionals must spend more than 750 hours of personal service hours working in one of the real property trades or businesses outlined above.
Personal service hours are hours spent managing the operations of your real estate business. Not every hour you actually spend on your real estate business counts towards this test: the only hours that count are hours where you materially participated in managing your rental properties.
3. Material Participation Test
So, what does it mean to materially participate in managing your real estate portfolio?
At a high level, to materially participate you must be actively involved in managing your properties on a regular, continuous, and substantial basis.
The IRS specifies seven tests that an individual can use to determine whether they satisfy the material participation requirements. You only have to pass one of these tests. We explore these seven tests in detail here, with illustrated scenarios that outline exactly what does (and doesn’t) constitute material participation: Real Estate Professional Status for Landlords: The Ultimate Guide to Eliminating Your Tax Bill While Sleeping Well at Night
One key element to note: if you own multiple properties, you must elect to have them grouped together by making a grouping election. Otherwise, you’d have to prove that you materially separately participated in each rental property that you own. However, making a grouping election doesn't always make sense, particularly for investors with suspended passive losses. We encourage you to consult with a real estate tax expert before making this election.
Substantiating Your Position as a Real Estate Professional
Individuals who elect to real estate professional status are more likely to face audits. In the event of that happening, the burden of proof is on the taxpayer to show that they met each of the tests outlined above.
You should collect this body of evidence on an ongoing basis. Many real estate professionals maintain weekly time logs, backed by evidence including receipts, emails, and calendar appointments. If you’re audited, this documentation is vital in helping you substantiate your position.
Partner with a Specialized Real Estate Accounting Firm: Hall CPA
Real estate professional status is a complex area of the tax code. Qualifying as a real estate professional is not a decision investors should take lightly: you have to put in the hours actively managing your portfolio and maintaining pristine records of your time. But for individuals who meet the qualifications above, the tax benefits can be significant.
To ensure you meet all the qualifications for REPS and are able to substantiate your position in case of an audit, it’s best to partner with an experienced real estate tax advisor that has a track record of helping individuals in a similar situation.
At Hall CPA, our tax advisors are focused exclusively on the needs of the real estate community and have extensive experience helping taxpayers qualify for and document their status as a real estate professional.
To learn more about how Hall CPA can support your real estate tax planning needs, contact us today.