This is the third episode in our REPS series, we discuss myths and strategies behind the real estate professional status.
Since you've already listened to the first two episodes in this series, you know the REPS is one of the most litigated parts of the tax code - and for good reason! People really want to take their rental losses against their active/ordinary income. This is very lucrative.
We want to set the record straight and tell people what they need to hear to win IRS audits. Some of the myths we will discuss today are things that we've heard other practitioners or educators tell their clients.
Myth 1: REPS can be achieved with 500 hours of material participation time and 250 hours of ANYTHING ELSE.
This is FALSE.
You must have at least 750 hours in a real property trade or business and it must represent more than half of your total working time.
Myth 2: Material participation hours and REPS hours are different.
This is FALSE. They're synonymous.
Material participation hours and REPS hours are the exact same types of activities.
Myth 3: If I hit 100 hours and more than anyone else, I'm golden!
This is FALSE.
This is just one of the tests for material participation - 750 hours still must be hit for REPS.
Myth 4: You can invest out of state, manage your property manager, and still qualify as a real estate professional.
This is generally FALSE
Typically, when you manage a property manager, this activity is not a material participation hour, because it's not integral to the continued operation of the rentals.
The caveat is if you have a very large portfolio of rental properties. If your portfolio is quite large, you are likely a real estate professional.
Myth 5: Education and research hours count.
This is FALSE. These hours do not count. If anyone tells you these hours count, ask for a citation!
"Ask for a citation, they should be able to back it up. We can back it up, we have tax court cases. People that say education and research time count, as far as I'm aware, they can't back it up. I'm not aware of a citation that supports this notion. It's important for real estate investors to know that they CAN ask their professionals for citations."
Myth 6: Hitting REPS is easy!
This is generally FALSE, unless you're a true legitimate real estate professional who works in a real property trade or business.
Myth 7: REPS hours do not carry over year to year.
This is TRUE. REPS hours DO NOT carry over year to year.
"This is an annual test. What you did last year does not matter for the following year. REPS hours do not carry over year to year. You have to qualify each year."
Myth 8: Qualifying as a real estate professional will unlock previous suspended passive losses.
This is FALSE.
If you have passive losses that are unused, they become suspended passive losses. Let's say, one year, you qualify as a real estate professional. You cannot use your previous suspended passive losses simply by qualifying as a real estate professional!
"Qualifying as a real estate professional does not unlock previously suspended passive losses. Those passive losses are treated as a former passive activity loss, it's still suspended. It remains suspended even though you've recharacterized your activity."
Strategies to Actually Qualify
Strategy 1: Have 1 spouse qualify as a real estate professional. Once one spouse qualifies, both qualify. One spouse would qualify as a real estate professional completely on their own. Spouses can combine hours for the purposes of material participation in the rental activities.
Strategy 2: Time your real estate professional status election with activities that will generate large losses. Make sure you can claim the losses. For example, you may choose to wait to execute a cost segregation study until a year where you know you're qualifying as an RE Pro. Form 3115 with a 481(a) adjustment allows you to execute a cost segregation study at any time.
Strategy 3: Run a separate real property trade or business in addition to being a landlord. Flippers, developers, property managers, agents, and brokers can more easily hit the 750-hour test. All time in real property trades or businesses can be grouped together.
Strategy 4: Buy local properties. If you're investing remotely or in syndications, it's very difficult to materially participate. Buy properties locally and rehab them and/or place them for rent and manage them as rentals or flip them.
Strategy 5: Make the -9 election to group all of your rental activities as one. Without this election, investors must materially participate in each individual rental. With the -9 election, all real estate is aggregated and treated as one activity, and material participation is judged on the entire portfolio. If you invest in syndications as a limited partner, this -9 grouping election is the only way to unlock these losses.
Strategy 6: Document everything! If you get pulling into tax court, you absolutely must have this information. A legitimate time log is critical. Keep your time log on a daily or weekly basis. Keep receipts and get your bookkeeping in order.
Strategy 7: What happens if you can't qualify as a real estate professional? Is there any way to take passive losses against ordinary income? YES - this is a loophole! It's called the short-term rental loophole.
If your property has an average stay of 7 days or less, then it's not considered a rental property for the passive activity rules (Tres. Reg. Sec. 1.469-1Te32A). AirBnb or VRBA properties. In this situation, you do need to achieve material participation. See the material participation tests in REPS 02. These losses will be nonpassive. This is not a rental activity - it's a commercial activity.
Section 469 says that all rental activities are passive by default UNLESS you qualify as a real estate professional. However, short-term rentals aren't a rental activity! Thus, material participation is the only test that must be met.
Don't try and get creative with real estate professional status. People inflate their time and log hours that don't count. Don't do this.
Be sure to tune in next week for the final episode in this series regarding IRS audits of REPS.