Business Management

Your Complete Guide to the Real Estate Professional Tax Loophole

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If you are an investor (which of course you are; otherwise, you would probably not be here on BiggerPockets), you may have already heard of the wonderful tax benefits of being a real estate professional.

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If you haven’t heard, here is a quick snapshot.

Tax Perks for Real Estate Professionals

For taxpayers who invest in rental real estate, we can always use our expenses and depreciation to reduce our rental income. However, if we have more expenses than we do rental income, there are a set of rules which determine whether or not we can use those excess losses to offset income from other sources such as our W-2.

In general, if you make $100k or less each year, you can have up to $25k of excess rental losses to offset your other income. If your total income is between $100k and $150k, then you can only use part of your excess losses to offset your other income.

If you make over $150k, then you generally cannot use any of the excess real estate losses to offset your other income. These excess losses are called “passive losses” and are carried forward for you to use to offset rental income or capital gains on the rental property in future years.

great-deal

It is important to note that in all three of these scenarios, we are talking about "excess" losses. We can always use our expenses and depreciation to reduce our rental income down to zero, but the limitations only come up in situations where you have more losses than income for any given year.

Now, if you happen to be someone who makes $150k or more and also had a bad year in real estate where you had some large losses, there is a potential way to still use the excess rental losses to offset your other income. The way to do that is using the real estate professional tax loophole.

Related: 3 Reasons You Should LOVE the Home Office Tax Deduction

For someone who is a real estate professional if they have a total income of $200k and net rental losses of $50k, this means that they can use $50k of losses to bring down their total taxable income to $150k. On the other hand, if this taxpayer was not a real estate professional, then their taxable income would remain at $200k for the year.

So now that you know the benefit of being a real estate professional, what exactly is this real estate professional loophole, and how can you take advantage of it?

The Ins & Outs of the Real Estate Professional Tax Loophole

Contrary to popular belief, you do not need to be licensed as a real estate agent in order to be considered a real estate professional. It has nothing to do with your education, professional licenses that you hold or what type of business you are in. Rather, the IRS determines real estate professional status based on a different set of criteria.

It involves the type of activity that the taxpayer is conducting in that year for the properties, as well as the amount of time spent on such activities. Simply put, the taxpayer (or spouse) needs to meet two requirements in order to qualify for the tax benefits of being a real estate professional.

The Requirements

  1. Spend more time in real estate activities than other “non-real estate” business activities combined.
  2. Spend at least 750 hours per year in real estate activities.

Please note that both requirements must be met in order to be designated as a real estate professional in the eyes of the IRS.

Related: 4 Depreciation Tax Mistakes Investors Need to Avoid

Another key item to note is that only the taxpayer or spouse needs to meet the qualifications, and they both get to use the losses to offset income.

Let’s go over some examples of how this works.

Example 1:

Let’s say that we have Jim, a single person who works a full time job of 40 hours a week and earns $200k for the year.

For Jim to qualify as a real estate professional, he would need to spend more than 2,000 hours per year in real estate in order to meet both rules.

Example 2:

Tom and Ann are married and own 5 rentals. Tom works full time at his job making $200k per year, and Ann is a stay at home mom. As long as Ann spends more than 750 hours actively involved in their rentals, they can use the excess losses on the rentals to offset Tom's W-2 income without limitations.

first-note-investment

The reason is that since Ann does not have a job or work activities that earn income, she only needs to meet the 750 hours of active participation in order to be a real estate professional.

If we changed this up a bit and the only difference was that Tom spent 300 in real estate activities and Ann spent 600 hours in real estate activities, do they meet the real estate professional rules?

Unfortunately, the answer is no. The reason is that a couple cannot combine their hours in order to meet the requirements. The hours requirement must be incurred by one person in order for that person to qualify as a real estate professional.

So if you are someone whose rental losses have been limited and feel that you or your spouse could potentially meet the requirements of being a real estate professional, be sure to speak with your tax advisor on this great loophole!

[Editor’s Note: We are republishing this article to help out our newer readers.]

Have you ever used the real estate professional tax loophole? Do you meet its requirements?

Let’s talk in the comments section below!

Amanda is a CPA specializing in tax strategies for real estate, self-directed investing, and individual tax planning with over 18 years’ experience. She is also a real estate investor of over 10 ye...
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    Sean Carroll Investor from New York City, New York
    Replied about 3 years ago
    In prior years I was not a REP and our income was over 150k so I carried forward the losses. In 2017, I anticipate to be able to meet the guidelines for REP. When and how can I claim those losses? Do I still need to sell the property in order to claim the carried forward losses? Thanks!
    Ed Taylor Investor from Venice, Florida
    Replied about 3 years ago
    I’ll echo the comments others have offered – good article. Please expand on the status and role of the investor (I’m a long term hold landlord) but a flipper – rehab/short term hold/sell – investor, despite meeting the 750hr threshold would not quality or would he?. If one did both, then it would be time invested on the long-term investment “hold” properties that would be used in the calculation. correct, or am I off base?
    Brad E. Investor from Okinawa, Japan
    Replied about 3 years ago
    Do I need to log my hours on a time sheet for verification in the event of an audit?
    Nate T. Investor from Tempe, Arizona
    Replied almost 3 years ago
    If you have another non-RE job, then yes it would be a good idea. If you are a full time landlord or similar then it’s probably not necessary.
    Jim Madden Investor from Plano, Texas
    Replied almost 3 years ago
    I am retired, on Social Security, and my wife works a W-2 job. We own nine single family rentals. If I am a Real Estate Professional, can my losses and depreciation be used to shelter IRA withdrawals, as well as passive income? Even if our Adjusted Gross Income is over $150,000?
    Mark Davis Real Estate Agent from Fairhope, AL
    Replied over 2 years ago
    I’m very new to investment property. I spoke to an owner of a rental home today I was attempting to get under contract to wholesale. During our conversation the topic of depreciation came up. He said that when he sells the property he would have to pay back in taxes the amount of depreciation he has claimed while he owned the home. Is this true and if so is there a way around this?
    Mark Davis Real Estate Agent from Fairhope, AL
    Replied over 2 years ago
    I’m very new to investment property. I spoke to an owner of a rental home today I was attempting to get under contract to wholesale. During our conversation the topic of depreciation came up. He said that when he sells the property he would have to pay back in taxes the amount of depreciation he has claimed while he owned the home. Is this true and if so is there a way around this?
    Gilbert Lugo from West Palm Beach, Florida
    Replied over 2 years ago
    How would you actually log these hrs or provide proof to the IRS that you actually have sufficient hrs?
    Dean I. from Jacksonville, North Carolina
    Replied over 2 years ago
    Looking for the same answer. In the mean time, I am keeping a log in a planner of what I am doing throughout the day. I own multiple businesses, but currently I spend more time on house flipping and I plan on picking up a few rentals to offset my other income, which I can only do if I qualify as a REP, since my income will be more than 150k this year.