The Basics of “Real Estate Professional” Status for Tax Purposes

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One of the biggest challenges real estate investors face is keeping the profits that they earn from their investments. Just like any other business, the IRS is going to want to take as big a chunk of your profits as possible, and knowing how to use the system to your advantage will help you keep as much of your hard-earned investing cash as possible.

One of the best ways to limit the financial impact of taxes when it comes to real estate investing is to be able to claim “Real Estate Professional” status on your tax returns. If you can do this (and that’s a big IF), you have some hefty tax advantages you can leverage to keep more of your investment profit. That said, there is a lot of misinformation about what it means to be a “Real Estate Professional,” so hopefully I can cover the basics here.

First, let me take a minute to explain in more detail the advantages of claiming “Real Estate Professional” status on your tax returns:

If you invest in real estate part time (not a professional), you may be able to deduct a portion of your passive RE losses on your tax return. If your adjusted gross income (AGI) is less than $100,000, you can deduct up to $25,000 per year in passive RE losses against that income. This benefit phases out (incrementally drops from $25,000 to $0) if your AGI is between $100,000 and $150,000. And if your AGI is over $150,000, you don’t get to take any RE losses in that year. That said, any losses can be “carried over” and used in subsequent years, based on the same AGI criteria.

The benefit to declaring “Real Estate Professional” status is that all real estate losses can be claimed against income in that year, without limitation based on AGI.

So, if a part time investor (who makes less than $100,000 per year) racks up $75,000 in real estate losses in 2008, he can deduct $25,000 of those losses in each of 2008, 2009, and 2010. If he continues to rack up losses in 2009, 2010, etc, those losses will also have to be carried forward. In contrast, a Real Estate Professional in the same situation can deduct the full $75,000 against AGI in 2008, and can do so with the additional losses in subsequent years.

The big question for most investors is not “Do I want to declare Real Estate Professional status?” but “Can I legally declare Real Estate Professional status?”

The IRS rules for claiming Real Estate Professional Status are very clear, and require that two key criteria be met in the given tax year:

  1. More than half of the professional hours worked throughout the year must have been devoted to material participation in real estate activities;
  2. More than 750 hours of material participation in real estate activities in the tax year being considered.

If you think you can satisfy both of those criteria in a given year, I highly recommend working with your CPA or accounting professional to ensure that you properly document your time and efforts to allow you to claim Real Estate Professional status, and in return, keep more of your hard-earned profits.

For more information straight from the IRS, follow this link

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22 Comments

  1. Thanks! Very clarifying! Your article sets the bar for self-qualification as a “Professional” in real estate. Now if we could get a self-qualifier for “Competent” much of the “carpet bagger” image held by a significant percentage of the general public, might leave on its own.

  2. Jeff Brown

    Stellar post on a much misunderstood, and unfortunately, abused option. Can’t count the number of investors who’ve called me after being busted by the IRS for having undeservedly claimed that status in their returns.

  3. Thanks J Scott. This is a confusing topic. Isn’t nice to see, that you don’t deserve to take the loss if you earn too much in one particular year. Maybe they’ll raise the tax rates too!

  4. Angie Menegay on

    Thanks for such an informative post. It made me start researching more on this topic, and from several IRS articles (gosh my head hurts), it sounds like the $150K limit applies to the combined AGI of married filing jointly returns as well. Can you (or someone) help confirm that since it makes no sense to me why the limit is not increased for couples versus individuals. I’d think 2 people are expected to make more than 1 person… So if a couple makes $150K combined, they can’t write anything off? Btw, we don’t qualify as RE professionals, so this option is already out of the window :-(

  5. Richard Dale-Mesaros on

    Hello!

    It would be great if you could do a similar synopsis of IRS “Dealer Status”, so everyone has a clear picture of how this impacts our business as an investor, too…….

  6. Great info J Scott. Many real estate investors miss this issue. I would also add that making an aggregation election is imperative otherwise the test you criteria you cite above will be applied on a per property basis. Here is recent tax court case and commentary that illustrates this point. Anjum Shiekh v. Commissioner

  7. Jon – Yes, if you are considered an RE Professional by the IRS, you can make unlimited legal deductions against your income.

    Angie – That’s a great point. I hadn’t really thought about this, but it appears that you’re correct. I have no idea what the rationale is for this limitation.

    Clint – Thanks for the follow-up…looking forward to reading about that case.

    Richard – I’ll write some more about Dealer Status in an upcoming post.

  8. Great article and info on a tough topic.

    I had this come up with my CPA back in 2008…and could have used this info then.

    We cam away with … its important that you document everything – and that everything you can do be documented.

  9. Angie Menegay on

    Thanks J Scott (And the article from Clint is fascinating as well). As much as I’d like to comply with IRS rules, I really hate them. So I was able to claim passive losses last year on my tax return because I make less than $100K. All of a sudden, now that I’m married and our joined income is more than $150K, I can’t claim any losses. Nothing changes but our marital status. Ugh. I can’t wait for more marriage penalty :(. I think the IRS is a marriage breaker!

  10. J. Scott: “Material participation?”

    So does virtual wholesaling count? It sounds like I’ll qualify in terms of time; if I spent only 3 hours a day every day finding and following up on leads, that would more than qualify me, especially since I don’t do anything else. Would material participation mean actually going out and looking at properties and talking to people in person, or does it include internet research, phone conversations, mailings, etc.? If it’s sole-proprietor, in-house, no employees, how do I prove how many hours I spent working? Would I need to purchase one of those fancy time-card clocks I used to slide my card through at temp jobs, or would they just look at my earnings, consider what it must have taken in man hours, and take my word for it?

    Jeff: unless someone has a full time job and they moonlight as an investor, how would someone fake something like this (750 hours a year? what?), or better yet, what would make the IRS accuse a person of “faking” their claim to being a real estate professional? Can you give us some examples?

  11. If my interest is in flipping (either wholesaling or rehab), does this even apply to my strategy? I know absolutely nothing about taxes, particularly when it comes to real estate. I’ve never worked enough to have to declare my income; I don’t even know how that’s done, or what form I’m supposed to fill out, or even where I’m supposed to get it.

    Here’s how little I know: if I flip a contract for a house I’m not actually buying, does that count as a capital gain, despite there being no expenditure of capital? How is that taxed? Can I declare it at year’s end along with all my other profits that I’ve figured out a way to shelter, or do I have to pay the taxes on each flip immediately, as if it were a lottery or gambling windfall? That’s how little I know about taxes.

    You all live in a world I don’t live in. I’ve never been given that opportunity because of my condition (read my profile for info on that). No offense to anyone here, but please excuse me when I say that this is all Greek to me. I need some background info here.

  12. Where’s the comment I posted? Not showing up. Here goes again…

    If my strategy is flipping, whether wholesaling or rehab, does this information even apply to my strategy? I know absolutely nothing about taxes, particularly when it comes to profiting from the sale of real estate. Do I pay taxes on each sale like I would if it was a lottery or gambling windfall, or do I declare it at years end with my collective profits after figuring out a way to shelter it? Honestly, folks, I know nothing about taxes. Being that I’m deathly allergic to sunlight, I can’t afford to go to jail on account of ignorance or bad information.

    I’ve never had to pay taxes, aside from what was taken out of the few paychecks I’ve earned. I’ve never talked to a CPA or tax attorney (no money for that), and the only people I’ve ever asked about it are my parents, who are too psychopathic to give me a straight answer on anything (literally, they’re psycho). I don’t know anyone I can ask offline, because I live out in the woods and only have contact with dumb crackers that work at the local grocery store. Can anyone help me understand this?

    I hate my life….

  13. Jeff Brown

    Michael — Many have thought all they needed was a RE license, and the rest would be ‘obvious’. I’m not sure how the rest got busted, though I will tell you that one couple, the husband had invested in one SFR rental, had the wife get a license then claim she qualified by managing the rental. :) A bunch of ‘em simply ‘assumed’ since they’d invested in a couple properties that by definition they were ‘pros’. Not makin’ that up. The rest of ‘em? I don’t know. I do know that it’s such an enticing advantage, many are willing to shade the facts to get it.

    • Wow, I’m glad I’m too paranoid to let that happen. I guess some people let things go to their head when they start making a little money. I know I’m ignorant, but at least I make an effort. Then again, I have the threat of death hanging over my head if I make even one stupid mistake.

      BTW Jeff, I considered what you had to say in your private email to me, and I’ve thought things through a little more. Your long-term paradigm doesn’t suit me at this time, but at least I can see now that my own at the time didn’t suit me either. Thanks for the advice you gave.

      Right now I’m saving my money to buy a virtual wholesaling course, which seems to be the only strategy I can implement right now. While I’m waiting to order the course, anyone have any info about the tax implications of wholesaling? Advice on tax minimization and sheltering of wholesaling profits?

  14. Brian McArthur on

    Thanks for a great article.
    Will moving title of rental properties from an individual to an S corp allow the individual (with over $150k/year in AGI) to take losses in the year they are realized rather tahn passively carry forward?

  15. Brian,

    The test is based upon your personal involvement. The choice of entity will not impact your individual 50% of time and 750 hour requirement. An entity is often used to avoid dealer status.

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