Top Advantages Of Real Estate Professional Tax Status

Real Estate Professional Status (REPS) gives individuals unique tax benefits that can significantly impact their financial outcomes (especially physicians and dentists). The Internal Revenue Service (IRS) sets strict guidelines to qualify for real estate professional tax status, which offers distinct advantages in reducing taxable income.

Achieving REPS can be a game-changer for high-income professionals. To qualify, individuals must meet specific eligibility criteria, including spending a minimum of 750 hours on real property businesses or trades annually and ensuring that these activities make up more than half of their professional time.

REPS allows qualified individuals to offset non-passive income (i.e., W2 income) with losses from rental real estate activity, thus reducing state and local tax obligations.

Naturally, you don’t have to master all the intricate details of the tax code – that’s where a dedicated real estate accounting firm comes into play. Nonetheless, a basic grasp of the core principles can be invaluable in ensuring you adhere to the rules throughout the year.

This article explores the requirements for achieving real estate professional status and how this can influence your tax responsibilities.

[Disclaimer: I’m not a financial advisor, lawyer, or accountant, so I advise consulting with your professional team on the topics discussed here.]

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What Is Real Estate Professional Tax Status?

The real estate professional tax status is a designation by the Internal Revenue Service (IRS) for individuals who operate real estate businesses and work in that business regularly.

This status allows investors to claim certain expenses on their taxes that they wouldn’t have been able to claim otherwise.

How To Qualify For Real Estate Professional Status

Obtaining real estate professional tax status doesn’t require owning real estate businesses or possessing a real estate license. Instead, there are three tests to pass.

Meeting these criteria can be challenging for a full-time employee such as a doctor. However, suppose your spouse satisfies all three conditions. In that case, their qualification as a real estate professional can make your rental losses fully deductible when filing a joint tax return.

3 tests for REPS:

#1. More than 50% test

In a tax year, more than 50% of your professional hours must be dedicated to services in a real property trade or business. The tax code characterizes a real property trade or business as any activity involving “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

#2. 750-hour requirement

You must spend at least 750 hours per year in a real estate business.

#3. Material participation requirement

Last but not least, you must materially participate in each real estate property trade or business.

What Are The Tax Advantages Of Being a Real Estate Professional?

Qualifying as a real estate professional offers several tax advantages:

Tax Advantage	Description
Unlimited Rental Loss Deductions	Initially, real estate professionals could deduct unrestricted rental losses against ordinary income. This has now been limited to $250,000 for single taxpayers and $500,000 for married taxpayers under the Tax Cuts & Jobs Act.
Passive Activity Loss (PAL) Exclusion	Real estate professionals can generally avoid the PAL rules under Section 469 of the Internal Revenue Code for their rental real estate activities. This allows them to offset passive income with passive losses without restrictions.
Lower Taxable Income	Real estate professionals can deduct qualifying expenses and losses from their overall taxable income. For instance, if a taxpayer earned $170,000 and had a combined rental property losses of $40,000, their taxable income would be reduced to $130,000.

Real estate professionals must maintain accurate records and documentation to substantiate their qualification for this tax status. Verifiable proof of the hours spent in real estate activities, as well as proof of material participation, is required in event of an audit.

What Are The Material Participation Rules?

Material participation in real estate activities is crucial for determining if a taxpayer qualifies as a real estate professional. To be considered materially participating, a taxpayer must be involved in the operations regularly, continuously, and substantially. 

There are various material participation tests used to determine if this involvement is sufficient, but you only need to meet one:

1. The taxpayer participates in the activity for more than 500 hours during the tax year.
2. The taxpayer’s participation in the activity constitutes substantially all of the involvement of all individuals for the tax year, including non-owners.
3. The taxpayer participates in the activity for more than 100 hours during the tax year, and no other individual participates more.

How To Document Material Participation?

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, especially during an IRS audit.

Related article: Navigating the IRS Audit Process: What You Need to Know

This could involve maintaining a real-time appointment book, calendar, Excel spreadsheet, or a written summary documenting the time spent on real estate activities. While documentation doesn’t necessarily have to be real-time, reconstructing records retrospectively can prove to be a difficult task.

Some forms of supporting documentation include:

• A detailed time log spent on real estate activities, with descriptions of tasks performed and hours worked.
• Records of expenses related to real estate activities, such as business expenses, payments made to property managers or agents, and expenditures on property improvements.
• Evidence of active participation, which could include correspondence with tenants, involvement in property management decisions, or engagement in activities like advertising, leasing, and tenant relations.

There have been numerous Tax Court rulings in favor of the IRS when taxpayers couldn’t provide sufficient proof of the hours devoted to their rental real estate activities.

Ordinarily, material participation is evaluated individually for each rental property. However, if you opt to consider all rental property interests as one real estate activity, you can make an election to do so. This choice, once made, is binding unless later revoked, and it applies to all subsequent purchases.

(Example) Qualifying For REPS

Let’s use a specific example to demonstrate how a dentist or another high-income earner might qualify for real estate professional status to use rental losses to offset other types of income.

Daniel is a full-time endodontist and owns the building where his clinic is located. His practice occupies a quarter of the building’s total space, and he rents the rest to a chiropractic office. Daniel and his wife, Emily, also own a condo and a commercial office space they rent to a tech start-up company.

Daniel doesn’t meet the “over 50%” condition with his full-time dental practice. However, Emily has chosen to be a stay-at-home mom for their three children over the last four years and doesn’t work outside the home.

Because Emily doesn’t have any other income sources, she only needs to prove that she spent 750 hours during the year, roughly 14 hours per week, engaged in rental real estate activities.

Assuming the couple decides to view all three properties as a single rental real estate enterprise, any time Emily spends managing these properties can be counted toward the 750-hour requirement.

Her activities might include:

Her activities might include:

• supervising repairs
• collecting rent
• marketing the units
• arranging lease agreements

Suppose Emily qualifies for real estate professional status and the three properties together result in a loss, which is a frequent situation when a property requires extensive renovation or is vacant for some time. In that case, the couple can apply these real estate losses to offset a portion of Daniel’s taxable dental income. Depending on their tax bracket, this could lead to significant tax savings.

Importance in Tax Status

Suppose a taxpayer qualifies for REPS and materially participates in their rental activities. In that case, any losses they incur can be considered non-passive losses. This means the losses can be used to offset other taxable income, potentially resulting in significant tax savings.

This is HUGE for high-income earners, allowing them to keep MORE in their pocket where it belongs.

On the other hand, if a taxpayer does not meet the material participation criteria, their rental losses are considered passive. Passive losses are limited in offsetting other income sources, which can lead to higher tax liabilities.

For instance, depreciation from investing in real estate syndications allows investors to offset their passive income distributions.

Understanding these rules can help you make informed decisions about their involvement in real property services and optimize their tax situation.

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What Are The Passive Loss Rules?

Passive activities are those in which an investor does not materially participate. Passive activity income includes rental portfolio income and other forms of profit generated from these passive activities. Passive losses, on the other hand, refer to deductions and expenses related to passive activities that exceed the income from those activities.

The IRS established the Passive Activity Loss Rules (PAL) to limit the ability of taxpayers to offset non-passive income with passive losses from rental properties and other passive activities. These generally apply to rental properties, partnerships, S corporations, and other tax-sheltered investments that generate passive income and losses.

To qualify for relief from the PAL rules, a taxpayer can assume the role of a real estate professional. Real estate professionals can deduct passive losses and offset their non-passive income, which is significant for tax planning. 

Want to learn more about how to avoid W2 taxes regarding the passive loss rules? Check out this video:

What Are Real Property Trades and Businesses?

Real property trade and businesses encompass a comprehensive range of entities, including development, construction, acquisition, management, and leasing.

This chart explains each in more detail:

Real Property Trades and Businesses	Description
Development and Construction	Includes planning, zoning approval, and financing of a project, as well as the actual physical work of constructing the structure.
Acquisition	Involves identifying, negotiating, and purchasing real property. This can include residential, commercial, or industrial real estate.
Management	Consists of overseeing the day-to-day operations of the properties, including maintenance, addressing tenant concerns, and financial management.
Leasing	Refers to the process of renting out available spaces within a property and handling lease agreements, rent negotiation, and marketing the property to potential tenants.

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What Is The Grouping Election?

Taxpayers who meet the criteria to be real estate professionals (like Emily and Daniel above) can choose to group their real estate-related activities into a single trade or business for tax purposes. By doing this, they can overcome the passive loss rules set by the Tax Reform Act of 1986.

What Are The Limitations To REPS?

While there are several benefits to electing real estate professional tax status, there are also some limitations:

#1. Earned income

Rental income from a taxpayer’s rental activities is considered earned income, subject to self-employment taxes.

#2. Passive loss limits

Tax deductions from investment partnership losses may be limited when deducted against earned income, as opposed to passive loss limits applied to passive income.

#3. Annual record-keeping requirements

Real estate professionals must provide detailed documentation proving material participation in their real estate activities each year.

Special Considerations

Married Couples and Joint Returns

If you’re married and trying to file for REPS status, then it’s essential to understand how the rules apply. One spouse can help meet the real estate professional status requirements if both spouses participate in the real estate trade or business.

Here’s an example:

• Spouse A works 2,000 hours a year as a dentist, a non-real estate trade, and 500 hours on rental real estate activities.
• Spouse B works 1,000 hours a year in a real estate trade and 750 hours on rental real estate activities.

Since Spouse B’s real estate trade hours (1,000 hours) represent more than half of their total work hours (1,750 hours), they meet the more-than-one-half test.

Both spouses also meet the 750-hour threshold, since Spouse A spends 500 hours and Spouse B spends 750 hours on their rental real estate activities, giving a total of 1,250 hours.

So, given this situation, the married couple qualifies for the real estate professional status on their joint return.

Role	Spouse A	Spouse B
Hours in non-real estate trade	2000 (Dentist)	0
Hours in real estate trade	0	1000
Hours in rental real estate activities	500	750
More-than-one-half test	Doesn’t meet	Meets (1000 out of 1750 hours)
750-hour test	Meets (500 hours)	Meets (750 hours)

Result: The married couple qualifies for the real estate professional status on their joint return because Spouse B meets the more-than-one-half test and both spouses meet the 750-hour test.

Net Investment Income Tax (NIIT)

Real estate professionals should know about the Net Investment Income Tax (NIIT). This is an additional 3.8% tax on certain net investment income of individuals, estates, and trusts. Individuals with Modified Adjusted Gross Income (MAGI) above specific thresholds are subject to NIIT:

• $200,000 for single filers
• $250,000 for married couples filing jointly
• $125,000 for married couples filing separately

Qualifying as a real estate professional might help reduce the impact of NIIT on a married couple’s taxable income. This is because the rental income from their investments would be considered non-passive (earned from an active trade or business) rather than passive, which is subject to NIIT. Therefore, their net investment income, which includes rental income, would be lower, potentially reducing the amount of NIIT owed.

Married couples need to strategize to meet the requirements for real estate professional status, considering both spouses’ contributions and participation. 

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Bottom Line

Hopefully, by now, you realize that obtaining Real Estate Professional Tax Status can offer valuable tax benefits, especially if you qualify.

While it may prove challenging to meet the criteria (especially if you have a full-time job), individuals in various roles within the real estate industry, including real estate investors, property managers, and brokers, can potentially qualify if they actively engage in their real estate activities and meet the required threshold for material participation.

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