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Of all the tax strategies available to individuals who own and operate real estate portfolios, qualifying as a real estate professional is perhaps one of the most attractive.
There are significant tax advantages to be had from claiming and substantiating this tax status, helping real estate operators significantly reduce their tax burden and accelerate their wealth accumulation journey.
When an individual substantiates real estate professional status, their income or losses from their real estate portfolio is characterized as non-passive. For real estate operators with high levels of income, that’s an extremely advantageous tax benefit that can save them tens, if not hundreds of thousands of dollars every tax year.
Who Can Become a Real Estate Professional?
While the tax advantages for real estate professionals are extremely attractive, it’s important to note that successfully electing to be taxed as a real estate professional is difficult.
Real estate professional status is a carve-out in the tax code that was designed for people who operate rental real estate as their full-time jobs. If you’re employed elsewhere, own a separate business, or have hired a property management company to manage your properties, you likely won’t qualify for real estate professional status.
Key tax rules for real estate professionals are material participation rules. To qualify as a real estate professional, an individual must materially participate in a real estate trade or business. There are seven material participation tests, and to qualify as a real estate professional, you must pass one of them.
Since this is an article about tax advantages for real estate professionals, we’re not going to go too deep on the whole concept of material participation here.
If that’s what you’re looking for, we suggest you go and make yourself a cup of coffee and then check out our 12,000+ word Guide to Qualifying as a Real Estate Professional. It’s an extremely comprehensive overview that covers everything you need to know about real estate professional status.
If, based on what you’ve read so far, you feel like you might be eligible to be taxed as a real estate professional, read on to discover the key tax advantages for real estate professionals.
Not sure you qualify right now? We encourage you to read on anyway. Becoming a real estate professional might be an option further down the road. Besides, we’ve also summarized some other highly-effective real estate tax strategies that can be adopted by those who don’t qualify for real estate professional status.
What Are the Key Tax Advantages for Real Estate Professionals?
When an individual invests in real estate, a popular tax strategy is to use depreciation to create losses against that real estate. However, thanks to Internal Revenue Code Section 469, the IRS considers losses from rental real estate investments to be ‘per se’ passive.
From a tax perspective, that means you can only offset these losses against other passive income, such as rental income from tenants in those properties. You cannot use them to offset your non-passive income: the income you actively earn through your W-2 job or ownership position in an active business.
Being taxed as a real estate professional means that your losses are characterized as non-passive and can be used to offset non-passive income. That’s a huge tax benefit that you can use to offset tens or even hundreds of thousands of dollars in actively earned income.
You should note that seeking these tax benefits is not without risk. Real estate professional status is one of the most litigated elements of the tax code. In the event of an audit, the burden of proof is on you to fully substantiate your position.
Other Real Estate Tax Strategies
If you don’t qualify as a real estate professional, there are plenty of other advanced tax strategies that you can apply to achieve significant tax savings. Many of these strategies are easier to qualify for, although you should still seek the support of a specialized real estate accounting firm to ensure you’re playing within the rules of the law.
Here is a brief overview of some popular tax strategies used by real estate investors who do not qualify as real estate professionals:
By undertaking a cost segregation study, real estate investors are often able to accelerate depreciation schedules to minimize their taxable income on properties. When used in combination with bonus depreciation, this is a powerful strategy that creates significant tax savings.
A 1031 exchange allows real estate investors to sell a property and use the proceeds to buy another property. The key tax advantage of the 1031 exchange is that the capital gains taxes from the sale of the property can be deferred.
For investors looking to grow their portfolio, the 1031 exchange is an invaluable tax strategy that enables them to expand into newer, more valuable assets without paying capital gains tax.
Short Term Rental Tax Loophole
If you operate rental real estate but do not qualify for real estate professional status, you might want to consider operating your rental properties as short-term rentals to take advantage of the short term rental loophole.
Much like real estate professional status, there are a lot of tax rules to be aware of here. But in general, operating a property as a short term rental can enable you to have your losses from this property be treated as non-passive––therefore enabling you to deduct losses against other non-passive income.
To learn more about short term rental tax strategies, view our Comprehensive Guide to Short Term Rentals.
Partner with an Experienced Real Estate Accounting Firm
No matter which tax strategy you choose to pursue, the support of a specialized real estate accounting firm is crucial.
That’s particularly true if you choose to go down the road of qualifying as a real estate professional. While the tax advantages for real estate professionals can be significant, effectively substantiating the position requires a detailed, well-planned approach backed by robust accounting practices.
If you’re interested in seeking real estate professional status or need other real estate tax advice, Hall CPA is here to help. With a team of CPAs exclusively focused on the real estate industry, our tax advisors have the skills, knowledge, and experience to design and execute a tax strategy that can deliver significant savings.
To learn more, contact us today.