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As a real estate investor, a sophisticated tax strategy is central to the success of your portfolio. Real estate is the single most tax-advantaged asset class––easily beating out stocks, bonds, or any other financial assets.
However, one limit to the tax benefits offered by real estate is that any income deriving from your real estate investments is treated as passive income. That income could include rent checks from your tenants or booking fees from short term rental guests.
Passive income is taxed at your marginal tax rate. For high earners, that could be as high as 37%. Depending on the size of your portfolio, these taxes could amount to hundreds of thousands of dollars a year.
Fortunately, there’s a way around this. Qualifying for Real Estate Professional Status (REPS) and materially participating in rental activities allows investors to convert passive losses and income into deductible ordinary losses and income. The result? A significant reduction in your tax liability.
However, qualifying as a real estate professional is far from easy, and it’s an area of the tax code the IRS isn’t afraid to litigate.
To leverage the status correctly, there are several steps you must take. Today, we’re focusing on one in particular: how to avoid passive activity.
Want a more comprehensive overview of qualifying for Real Estate Professional Status? The team at Hall CPA has you covered. Check out our 12,000+ word guide to Qualifying as a Real Estate Professional now.
Passive Activity vs. Non-Passive Activity: What’s the Difference?
As we explained earlier, income (or losses) generated by your real estate rentals is generally considered to be passive. You can only deduct passive activity losses against passive income, not the ordinary income you receive from your W-2 job or business ownership.
There are several exceptions to this rule that enable investors to classify their losses from rental real estate as non-passive. If a property is sold, all current and suspended losses can be used to offset non-passive income. Additionally, if an individual has a Modified Adjusted Gross Income (MAGI) of less than $150,000, they can deduct up to $25,000 in real estate losses.
However, let’s assume you operate your rental portfolio on an ongoing basis and have a MAGI above $150,000. To have your losses be classified as non-passive, you must both qualify as a Real Estate Professional under IRC Section 469(c)(7) and materially participate in the rental activities.
Pursuing this strategy is hugely powerful. Non-passive losses can be deducted against all of a taxpayer’s income, including W-2 income, business income, and investment income.
We’re not going to explore the steps you can take to qualify as a real estate professional here. If you’re interested in learning more about that, read this article: The Secrets to Qualifying as a Real Estate Professional.
Instead, we’re going to focus on how those who have already qualified as real estate professionals can avoid the passive activity limits and ensure their rental losses are treated as non-passive.
How Can Real Estate Professionals Avoid Passive Activity?
In isolation, the act of qualifying as a real estate professional means nothing. To ensure your losses are treated as non-passive, each year you must prove that you materially participated in your real estate rental activities.
This concept is important: material participation. What does it mean?
Per the IRS, you materially participated in a business provided you satisfied any of these tests:1. You participated in the activity for 500 hours or more during the tax year;
2. Your participation represents substantially all the participation in the activity of all individuals for the tax year. That includes the participation of individuals who have no ownership interest in the property, such as property management firms;
3. You participated in the activity for over 100 hours during the tax year, and your participation was at least as much as any other individual;
4. The activity is characterized as a significant participation activity, and you participated in all significant participation activities for more than 500 hours;5. You materially participated in the activity (other than by meeting this fifth test) for any five of the ten most recent tax years (these do not have to be consecutive years);
6. The activity is a personal service activity, and you have materially participated in the activity for any three previous tax years (these do not have to be consecutive years); or
7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Let’s be honest. Unless you’re a specialized real estate accountant, none of this is particularly easy to understand. That’s particularly true if you own multiple rental properties, which if you’ve chosen to qualify as a real estate professional, you most likely do.
If you own several rentals, you must prove you materially participated in each one for the losses to be treated as non-passive. It is possible to elect to have all of your rentals grouped together under IRS Regs. Sec. 1.469-9(g).
A word of caution: this can have negative long-term consequences, particularly if you have suspended passive losses or plan to sell a property. It’s highly recommended that you consult with a qualified CPA before making this election.
Tips to Avoid Passive Activity
So, with these complex regulations, what practical steps can you take to ensure you avoid passive activity? Here are three strategies:1. Track your time: keep a rigorous time log that documents all the hours you spent managing your real estate business. Do this throughout the year and collect a body of proof: calendar appointments, receipts, emails, and financial transactions. If the IRS comes knocking for an audit, you bear the burden of proof, not them.
2. Self-manage your rentals: if you hire a property management company to manage the day-to-day operations of your rental properties, demonstrating you materially participated is going to be an uphill battle.
3. Hire a specialized real estate accounting firm: this is a highly litigated area of the tax code. If you plan to pursue real estate professional status and have your rental property losses characterized as non-passive, it’s highly recommended that you work with a specialized real estate accounting firm with experience in this area.
These tips aren’t an exhaustive list. In most cases, the steps you take to ensure your rental income is classified as non-passive will be dictated by variables unique to your situation––underscoring the importance of having a team of experienced accounting professionals in your corner.
Hall CPA: Your Real Estate Accounting Firm
There are no shortcuts to having your rental property losses treated as non-passive. Doing so demands a deliberate, strategic approach, and a commitment from you, the investor, to put in the hours managing your properties. But with the guidance of the right accounting professionals, the tax benefits from pursuing this strategy can be extremely attractive.
If you need an accounting firm well-versed in dealing with the intricacies of real estate professional status, Hall CPA is here to help. Our team of specialized accounting professionals has a track record of supporting real estate investors around the nation to implement advanced tax strategies.
Interested in learning more? Request an initial consultation today.