By default, rental losses are passive. They can only offset other passive income. Qualifying as a real estate professional allows you to take rental losses against W2 or active business income.
Brandon and Thomas discuss how to qualify for the real estate professional status as well as material participation, two very important concepts to turn your losses nonpassive to offset your W2 or other active business income.
If you haven't already listened to REPS 01, check it out first. This is the second episode in a four-part series.
Statutory Test 1
1) Spend at least 750 hours in a real property trade or business in which you materially participate
What do hours mean? What does real trade or business mean? What does material participation mean?
There are 11 real property trades or businesses defined in Sec. 469: development, construction, redevelopment, reconstruction, acquisition, conversion, rental, operation, management, operation, or leasing.
Treasury Regulation Sec. 1.469-9 further explains these trades and businesses. Reading the examples, you'll find you that really need to be involved in the day to day operation of the business.
Day to day involvement is generally active. It's more active than anyone else. You can't position that you manage your rentals on a day to day basis if you have a professional property manager.
What if you have two separate real property trades or businesses? We see this most commonly with agents and brokers that also manage properties. For the purposes of the 750-hour test, you get to combine the time of all real property trades or businesses in which you materially participate.
To prove material participation you must meet one of seven tests.
Find citations in the Ultimate Guide
7 Tests for Material Participation
The 3 tests that are more common are the individual 500 hour mark, that the activity of the individual is substantially all, and that the individual participates more than 100 hours + no-one else spends more time than them.
Only one of these tests must be met to gain material participation.
"The real estate professional tests are: 750 hours and more than 1/2 your time. Those are the two tests. If you qualify as a real estate professional, your rentals are still passive... just qualifying as a real estate professional does not make your rentals nonpassive. You also have to prove the material participation test on your rental activities."
You and your spouse can combine hours for the time tests for the purposes of material participation. One person must hit 750 hour mark and spend over 1/2 their time for the real estate professional status. To demonstrate material participation in the rental activities, the hours of the spouse do count as well.
The Tax Court will audit time your time logs to see if your hours are substantiated, accurate, and reasonable. This always happens for these court cases. To qualify as a real estate professional and achieve material participation, you must keep great records.
Which Hours Count?
Litmus Test: Are your hours integral to the operations? If the day to day operations of your rentals are unaffected by the hours that you're logging, the hours do not count.
The hours that qualify must be substantially all hours and have a legitimate impact on the rental activities.
Activities that generally count: showing the property for rent, taking tenant applications & screening tenants, preparing & negotiating leases, cleaning & preparing the units for rent, repairs, improvements, managing the construction, purchasing supplies & materials, inspecting the property, responding to tenant complaints & inquiries, collecting & depositing rents, evicting tenants, writing & placing advertisements, and working on your website
Activities that don't count: education & research, investor-type activities, and travel time
Examples of investor-type activities include studying and monitoring financial statements, preparing financial statements, bookkeeping, preparing taxes, paying bills, and organizing records.
You should log ALL of your time and expenses for all of these categories, even though they don't count towards the 750-hour test. This is still valuable information to maintain. Deductions are still available for these business expenses.
Statutory Test 2
2) It must represent more than half of your total working time
You have to spend more time in real estate activities than anywhere else - including your full-time job. If you have a W2 job, spending 2,000 hours a year, you must spend 2,001 or more hours on real estate. Working 4,001+ hours in any calendar year, out of 8,760 hours in a calendar year, is not going to prove credible in the eyes of the tax court. If you try to tell this to the tax court, you're saying that you're working a 12 hour day, every single day, for 365 days - no holidays or vacation.
Out of 500+ tax court cases of real estate professionals with full-time jobs, only one case was upheld. When you show up to the tax court, you have to prove you're credible. That's extremely difficult to do with a full-time job.
"Real estate professional status is not that grey. People that sell it to you, if you go to an education platform, if you go to another CPA and they tell you it's grey, run! They do not understand it well enough to advise you. Real estate professional status is not that grey. The reason it's not that grey is because it's so heavily litigated, we have tons of tax court cases, literally hundreds, specifically on real estate professional status that provide us with guidance."
Make sure to tune in next week for part 3 about myths and strategies related to the real estate professional status!