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As a business owner, obtaining real estate professional status (REP) is an invaluable strategy that can provide you with tax benefits now and in the future. With this designation, you can offset a portion of the income from your practice with various deductions associated with managing rental properties, reducing your state and local tax obligations. This post covers what it means to qualify as a real estate professional and how it can impact your tax liability.
Real estate professional status is an IRS-approved way to get around the passive activity loss limitation rules.
The IRS generally presumes that all real estate rental activities are passive activities. Passive activity loss (PAL) rules limit a taxpayer’s ability to offset net losses from passive activities, including rental real estate, against other non-passive income, such as wages or income from self-employment. Ordinarily, any passive losses that exceed passive income must be carried forward. They can only be used when the activity generates a gain, or the taxpayer disposes of the activity.
There is an exception for lower-income taxpayers. Property owners with modified adjusted gross income (MAGI) of $100,000 or less can deduct up to $25,000 of rental real estate losses annually if they actively participate in the rental activity. The ability to deduct those losses gradually phases out as MAGI exceeds $100,000 and disappears entirely once MAGI exceeds $150,000.
Some successful business owners have income higher than the upper phase-out limit, most can’t offset ordinary income with rental real estate losses unless they qualify for real estate professional status.
Taxpayers who qualify for real estate professional status are not subject to the passive activity loss limitation rules. They can use rental losses to offset non-passive income.
Another benefit of qualifying for real estate professional status is that any rental activities that aren’t subject to PAL rules are also not subject to the 3.8% net investment income tax (NIIT).
To qualify as a real estate professional for tax purposes, you don’t have to own or work for real estate businesses or have a real estate license. Instead, you must pass three tests. Meeting all three tests is difficult, if not impossible, for a full-time business owner. However, if your spouse meets all three tests, having them qualify as a real estate professional makes your rental losses fully deductible on a jointly filed tax return.
Let’s look at those three tests in detail.
You must have spent more than 50% of your working time during the tax year performing personal services for a real property trade or business.
The tax code defines a real property trade or business activity as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
You must spend more than 750 hours participating in real estate business activities during the tax year. This can include the time spent acquiring or improving rental properties, managing rental property portfolios, and advertising for tenants.
Just keep in mind that you can’t combine time spent by both spouses to meet the 750-hour test.
Finally, you must materially participate in each real estate business or property. To have your activity qualify as material participation, you must meet one of the following tests:
Work more than 500 hours in the activity (a married couple can count the involvement of both spouses to meet this test)
Do substantially all the work in the activity
Work more than 100 hours in the activity, and no one else worked more than the taxpayer (including non-owners or employees)
The activity is a significant participation activity and your total time in all significant participation activities exceeds 500 hours
You materially participated in the activity in any five of the prior ten years
You materially participated in a personal service activity for any three prior years
Based on all facts and circumstances, you participate for more than 100 hours in the activity on a regular, continuous or substantial basis during the year
Practically speaking, this means you’re doing the work on your rental properties rather than hiring a property manager.
The three tests outlined above are applied annually, so you may qualify as a real estate professional in one year and not in other tax years.
To meet the requirements of real estate professional status, it’s essential to keep detailed records of activities and time spent working on the properties so you can verify your real estate professional status in the event the IRS decides to audit your return.
For example, you may keep a contemporaneous appointment book, calendar, or narrative summary of the time spent performing real estate activities. Your documentation doesn’t have to be contemporaneous but trying to recreate records after the fact can be challenging. In fact, numerous Tax Court cases have found in favor of the IRS when a taxpayer can’t document enough hours spent providing personal services to their rental real estate activities.
Generally, material participation is determined separately for each rental property. However, if you prefer to treat all rental property interests as a single rental real estate activity, you can make an election to do so. That election is binding unless you later revoke it and covers all future purchases.
Because of the 750-hour requirement, it’s unlikely that you’ll be able to qualify as a real estate professional if you own only one or two properties (unless one of them is undergoing significant renovations). However, if you own several properties and manage them yourself, it’s well worth documenting the time you spend working on and managing them.
Let’s consider an example to show how a physical or another high-earning professional might qualify for real estate professional status in order to use rental losses to offset other income.
Sita is a full-time physician and owns the building that houses her practice. Her practice takes up half of the building’s square footage, and she leases out the remaining space to a dental practice. Sita and her husband, Manuel, also own two residential rental properties and a commercial retail space they rent to another business.
Because Sita works full-time in her medical practice, she doesn’t meet the “more than 50%” test. However, Manuel doesn’t have a career outside the home as he’s been focused on raising the couple’s two children for the past five years. Because Manuel is not earning income from any other sources, he only needs to show that he spent 750 hours for the year—roughly 15 hours per week—working on rental real estate activities.
Assuming Sita and Manuel elect to treat all four properties as a single rental real estate activity, any time Manuel spends managing the properties counts toward the 750-hour criteria. This might include performing or overseeing repairs or improvements, collecting rent, promoting available space, and showing or leasing the properties.
One thing to note: investing activities, such as researching new rental properties to purchase, does not count toward the 750 hours.
If Manuel qualifies for real estate professional status and the three properties combined generate a loss—not an unusual scenario when a property needs significant repairs or is unoccupied for several months—the couple can use the losses generated by their real estate investments to offset a portion of the taxable income generated by the medical practice. Depending on their tax bracket, that can result in significant tax savings.
What if you own short-term rentals, such as Airbnb or VRBO properties? The good news is that short-term rental activities are not considered rental activities under IRS rules, so you do not need to qualify as a real estate professional to deduct losses associated with these activities. However, you must demonstrate that you materially participated in the activity during the tax year (generally, 100 hours a year) and the property’s average tenant stay is 7 days or less.
People without an available spouse to manage their real estate portfolio may choose to invest in short-term rentals to avoid passive activity loss limitations.
Qualifying as a real estate professional in the eyes of the IRS is only beneficial if your rental real estate investments generate net losses. If your properties generate rental income, there are no losses to offset other income. At this point, you may want to consider investing in other real estate or other investments to create losses to use against the income. If you’re a business owner who owns rental properties or is thinking about getting into real estate, qualifying for real estate professional status may allow you to use rental losses to offset other taxable income. First, it’s crucial to ensure you meet the requirements and accurately track the time spent on real estate activities. If you need help navigating the often murky waters of passive activity loss rules and rental activities, check out HOW WE WORK to see if you are a good fit for complementary tax analysis.