Table Of Contents
If you’re a real estate investor, you’re likely well aware of the tax benefits that come with building a portfolio of rental properties.
With the right tax strategy, real estate investors can save tens of thousands of dollars in taxes each year, accumulating new assets and growing their wealth in a tax-efficient manner.
However, to effectively avail yourself of these tax benefits, you should have a firm grasp of the tax rules for real estate investors. Whether it’s navigating the intricacies of a 1031 exchange or understanding how to deduct the cost of property repairs, knowing your way around the tax code is a key component of your success.
For those electing to be taxed as real estate professionals, some knowledge of the tax code is even more important. Being taxed as a real estate professional offers significant tax advantages, but equally, you’re more likely to be audited and your tax position must be defensible. To be successful, you need to have a basic understanding of the tax rules for real estate professionals.
Of course, you don’t need to understand every little complexity of the tax code: that’s why you hire a real estate accounting firm. But it’s extremely helpful to have an understanding of the key concepts to make sure you play by the rules throughout the year.
Looking for a more detailed explanation of tax rules for real estate professionals? Our 12,000+ word guide to Qualifying as a Real Estate Professional has everything you need to build a robust working knowledge of the tax rules for real estate professionals.
What is a Real Estate Professional?
It’s easy to get confused about what a real estate professional is. After all, it’s a very general term. At first glance, you might think it would apply to brokers, investors, property managers, and so on. But from a tax perspective, the term ‘real estate professional’ has a very specific definition.
A real estate professional is simply a designation that you elect on your tax return. By electing to be taxed as a real estate professional, individuals can use the losses from their real estate activities to offset any income––including non-passive income earned through a W-2 job or business ownership.
That distinction has the potential to unlock serious tax savings for savvy real estate investors. Without securing real estate professional status, investors can only deduct the losses from their real estate activities against other passive income.
However, not every real estate investor qualifies as a real estate professional. There are many tax rules for real estate professionals and to substantiate this position individuals have to meet a series of specific criteria.
Let’s explore exactly what these conditions look like.
What Tax Rules Do Real Estate Professionals Need to Know About?
A lot of real estate investors are drawn to the tax benefits of becoming a real estate professional, but the reality is that real estate professional status isn’t the right fit for everyone. There are a variety of tax rules for real estate professionals. Three of the most important include:
- Passive loss rules
- Real property trade or business rules
- Material participation rules
Read on for an overview of the key tax rules real estate professionals need to understand in each of these categories.
Passive Loss Rules
Per IRC Section 469, rental real estate is considered to be a ‘per se’ passive activity. This characterization means that by default, losses from rental real estate (typically achieved by depreciation) can only be used to offset other passive income: such as rental income.
For investors, this means that losses from a rental real estate portfolio cannot be used to offset non-passive income, such as income from a W-2 job or business ownership. This can limit the potential tax benefits of investing in real estate.
Real estate professionals, broadly considered to be individuals who operate their real estate business full-time, can claim an exception from this treatment by pursuing real estate professional status.
Alone, however, qualifying as a real estate professional does not deliver any tax benefits. Individuals must prove they materially participated in a real property trade or business during that tax year. Let’s take a closer look at the rules that govern those tests.
Real Property Trade or Business Rules
To have your losses be treated as non-passive, you must participate in a real property trade or business during the tax year. If you operate your own real estate portfolio, you likely satisfy this requirement. However, it’s worth knowing exactly what the rules and tax court precedent state.
The IRS specifies 11 types of real property trades or businesses. To qualify as a real estate professional, you must perform at least 750 hours of personal services by materially participating in one of these activities (more on material participation in a moment). You should also own at least a 5% equity stake in the real property trade or business.
The 11 categories are real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.
This is a fairly lengthy list with some pretty broad categories. There’s one important distinction to be aware of. Generally speaking, Tax Court precedent has shown that those who provide services to the real estate industry (such as real estate tax firms like us), cannot use those service hours towards qualifying for real estate professional status. That’s because we’re providing professional services, not real property services.
Material Participation Rules
Another important tax rule real estate professionals need to understand is the concept of material participation. To have rental losses be treated as non-passive, real estate professionals must show that they materially participated in their rental business.
What does that mean? To materially participate, individuals must pass one of seven tests outlined by the IRS. We explore what those tests are in this article: Real Estate Professionals: Avoiding Passive Activity. Of the seven tests, the 500-hour participation rule is the one that is most commonly used by real estate professionals.
These hours must be spent on certain activities related to your real estate property. Generally, only activities directly related to your rental real estate count: tasks like processing tenant applications and working on repairs. Time spent on activities like education, research, and travel generally does not count.
You must meticulously track every hour you spent on your rental business and collect documentation that backs this up. In the event that you’re audited, the burden of proof is on you, not the IRS, and having receipts, calendar appointments, and emails that substantiate your position is vital.
Partner with a Specialized Real Estate Accounting Firm
This is a simplified version of the tax rules for real estate professionals, and in truth, there are many additional layers of complexity that we didn’t explore here. But with an understanding of these core concepts and a reliable real estate accountant, there’s no reason you can’t enjoy the tax benefits that come with qualifying as a real estate professional.
At Hall CPA, we specialize in tax planning services for the real estate community. Our CPA firm works with thousands of real estate investors across the nation to build advanced tax strategies that help unlock significant tax benefits.
To learn more about working with us, contact an advisor today.