For high-income investors, real estate professional tax status is undoubtedly one of the most powerful tax tools. It can potentially help someone bring their tax bill from 35% down to 15%—or lower.
To meet the real estate professional tax status requirements, you must work at least 750 hours during the tax year in a real estate trade or business. Additionally, more than half of your annual working hours must be in that real estate trade or business. That means you can’t qualify if you work a full-time job.
Tax Perks for Real Estate Professionals
Taxpayers who invest in rental real estate can always use expenses and depreciation to reduce our rental income. However, if we have more expenses than we do passive 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 $100,000 or less each year, you can use up to $25,000 of excess rental losses to offset your other income. If your gross income is between $100,000 and $150,000, then you can only use part of your excess losses to offset your other income.
If you make more than $150,000 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.
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, you can potentially still use the excess rental losses to offset your other income. This is done using the real estate professional tax loophole.
A real estate professional with a total income of $200,000 and net rental losses of $50,000 can use those losses to reduce their total taxable income to $150,000.
The Real Estate Professional Exception
What exactly is a real estate professional, and how exactly does someone qualify for that designation? Let’s start with our two sample real estate investors: Darin and Jamie. Neither of them are really interested in getting a real estate license and giving up their weekends to hold open houses.
Contrary to popular belief, you do not have to be in the business of selling real estate, be an agent, work under a broker, or show houses for sale. In fact, you don’t even have to be licensed as a real estate agent. Real estate professional status is a term that exists only in the tax world, as defined by the IRS. It has nothing to do with the degree you went to school for, nor which licenses you may hold.
And just because you are licensed in real estate does not automatically mean you are eligible to be a real estate professional in the eyes of the IRS. To receive the tax benefits of being a real estate professional, you simply must meet the hour and participation requirements of the IRS.
The person claiming real estate professional status must spend at least 750 hours participating in “real property trades”—or the real estate business, as defined by the IRS. This time is calculated on an annual basis from January 1 to December 31, not on a weekly or monthly basis. For example, it would be perfectly fine for Jamie to spend no real estate time in January through March, as long as she spends at least 750 hours for the rest of the year from April through December.
Activities that the IRS states meet the professional status requirements include:
- Development or redevelopment
- Property acquisition
- Rental management
- Brokerage trade or business.
Primary job requirement
That person must also spend more time in real estate than in their other jobs combined. If Jamie is a stay-at-home mom and was not working to earn income from any other sources, she only needs to show active “personal services,” or work time, for 750 hours for the year to claim real estate professional status.
But what if Jamie works a side business, such as freelancing from home? She can still claim real estate professional status if she meets all the requirements. As an example, if Jamie spends 1,000 hours on her freelance business and spends 1,001 hours in real estate, then she can claim real estate professional status and receive the tax benefits.
In that situation, she meets both requirements by spending at least 750 hours in real estate and spending more time in real estate than her side business.
Single taxpayer requirement
The time requirements above must be met by one taxpayer and cannot be a combined time of two individuals. In other words, Darin and Jamie cannot combine their real estate time to meet the 750-hour requirement. In order for Jamie to meet real estate professional status, she needs to meet both time requirements above on her own. Any time that Darin spends on real estate does not help Jamie.
Real estate professional activities do not need to be specifically related to rental properties. For example:
- What if Jamie gets licensed as a real estate agent or broker—or even open her own brokerage?
- What if she decides to start her own side business managing properties for other investors in her local area?
- Maybe she decides that she loves the rehab process and starts flipping properties on her own.
In all three of these scenarios, Jamie’s time as an agent, property manager, or flipper all counts toward her real estate professional time, even though the work she’s performing is not directly related to her rentals.
Here’s another great thing about real estate professional tax benefits: As soon as one of the two meets the qualifications, both receive the benefits. Jamie’s rental losses can offset Darin’s medical income—even if Darin himself is not a real estate professional.
Investors also must show that they “materially participate” in the rental properties that they own. That means they’re involved in the operations of their real estate in a regular, continuous, and substantial way.
The IRS has a number of tests that may be used to determine whether the taxpayer meets the requirement. (For more details, see the “Material Participation” section of the IRS’s passive activity guidelines.) You only need to meet one test to qualify for material participation. One of the most commonly used is the 500-hour test. This means you must spend at least 500 hours during the year materially participating in your rental properties.
Although material participation is limited to the time spent on properties owned by the investor, time incurred by both spouses can be combined to meet this 500-hour requirement, assuming they are married filing jointly. If Jamie spends 400 hours on their rentals and Darin spends 100 hours, they would still meet the 500-hour test.
How to Document Your Real Estate Professional Activities
How exactly do you prove your rental real estate activities to the IRS? As with many things in the tax world, it all comes down to documentation. The IRS requires that the taxpayer keep a log of their hours of services during the year. There is no specific method required—you can keep appointment books, an online calendar, a time-tracking app, an Excel workbook, or even log your hours in a notebook.
The IRS does require that the time log be kept using a consistent method for the entire year. They don’t like time logs that are partially kept in a notebook, partially in Excel, and partially on a calendar. The time log should also be kept and maintained throughout the year—the IRS gives more weight to time logs that are completed while you are incurring the time versus time logs created after the fact.
Make sure to include:
- The date
- A description of the activity performed (as specific and detailed as possible)
- The duration of the activity
- The related property address.
For example: 03/01/19 • Met with the property manager to view repairs proposal • 3321 Main St rental • 2 hours
From an audit protection perspective, it’s recommended that your time log includes activities that can be verified and substantiated. In the event of an audit, the IRS may ask to review your time log. They may also take sample selections for testing. If your time log is made up of, say, 200 logged entries, they may randomly choose 10 entries and ask you to prove you spent time as stated. Keep copies of emails, phone calls, text messages, receipts, and car mileage to prove your case in the event of an audit.
What about “unprovable” time?
Of course, not everything can be proven with paperwork. What about the time that you dropped in on an open house and chatted up a Realtor who ultimately sold you another rental? No correspondence proves you were there, except maybe a business card you grabbed from the table.
In these cases, apply the “reasonableness test” when recording your time. If you were sitting across the table from an IRS auditor and making your case, would they consider an hour chat at an open house reasonable? Probably. Would it be reasonable that you spent five hours chatting? Probably not.
There are right and wrong ways to keep track of your time for real estate professional status. First, the IRS does not like ballpark time estimates. The time spent must also be credible. For example, an IRS auditor disallowed one taxpayer’s claim—he said he spent 24 hours replacing four window blinds, 56 hours replacing a toilet, and 280 hours closing the books of his rental properties.
Believe it or not, the IRS has caught taxpayers who logged more than 24 hours of real estate activities in a single day.
To claim real estate professional status while working a full-time job, track your time in detail. It is difficult for an investor with a full-time job to show more time was spent in real estate. If you worked 2,100 hours at your full-time job for the year, you must spend at least 2,101 hours in real estate in order to claim real estate professional status.
But suppose you are very efficient at your job? What if you get paid to work eight hours a day but you can do your job in three hours? For the rest of your workday, you sit at your desk and search for real estate deals online. Unfortunately, the IRS still deems that to be an eight-hour workday, so efficiency does not reduce the work hours for real estate professional purposes.
It is possible, though. A commercial boat pilot successfully proved that he spent more time fixing up his rental properties. He showed before-and-after pictures from his rental and had witnesses testify to his extraordinary work ethic. The IRS found his time log to be credible and reasonable and allowed his claim as a real estate professional, although he also earned income outside of real estate.
Real Estate Professional Tax Benefits
A number of strategies can decrease your taxes once you qualify as a real estate professional. Start with cost segregation to accelerate the depreciation on your new rentals. Accelerated depreciation lets you push the expenses into the current year by breaking out the components of each rental.
When Jamie and Darin used this accelerated depreciation schedule, their projected net tax loss from their rentals became $67,000. Here is a comparison of Darin and Jamie’s tax bill with and without real estate professional status:
*This is typically how accountants write charts. All numbers inside the parenthesis are a loss or negative.
By claiming real estate professional status for Jamie, the $67,000 of rental losses can offset the income Darin makes from his medical practice. This helps them save $30,150 of cash—in just the first year!
Common Tax Mistakes
For Darin and Jamie, the difference between claiming real estate professional status and not is a significant amount—$30,150. Not claiming this status (if you qualify) is probably the most common and costly tax mistake made by real estate investors. It’s not as simple as listing “real estate professional” as your occupation on the tax return. There is no box to check or form to fill out.
In fact, claiming the real estate professional status is almost trickier than qualifying for it.
Not aggregating your rental properties
One of the hidden traps relates to the material participation requirement—which actually applies to each rental property the taxpayer owns. Remember, there are several tests a taxpayer can use to pass the material participation test, including the 500-hour test. But all these tests are supposed to be applied separately to each rental property.
As an example, let’s assume Darin and Jamie want to use the 500-hour material participation test. If they own five rentals, they need to spend 2,500 hours on their rental properties total. One way to avoid this requirement is to include an election with your tax return aggregating your properties into one activity. With this, you only need to show 500 hours total for all your rentals combined for the year to pass the material participation test.
To many investors, and even CPAs, this requirement makes no sense. Why does the IRS require we attach a piece of paper to our tax return in order to treat all rentals as one property? There have been many cases where the investor would have otherwise qualified for the hours’ requirement, but the IRS disallowed the tax deduction simply because the election was not attached to the return.
An example of this might read:
“Jane Smith hereby elects to combine all rental real estate interests into one activity pursuant to Code Sec. 469(c)(7)(A) and Reg. §1.469-9(g)(1).”
Forgetting to review past returns
Look at your previous years’ tax returns for an election to aggregate your properties. The IRS released legislation that says for certain taxpayers, it may be possible to file an amended return for the real estate professional status. To claim real estate professional status on your tax return the right way, make sure to keep these items in mind:
- Have a logbook to accurately track your time during the year and retain it for your records.
- Make sure you list your occupation on the tax return as a real estate professional.
- If you own more than one rental property, make sure you include an election to aggregate your rentals.
- Ensure that the return is being calculated to allow any rental losses to offset your other non-rental income.
In Darin and Jamie’s case, investing in rental real estate helped them increase their cash flow by $1,500 per month. That means more money in their pockets—which can be a down payment on another rental property. Claiming the real estate professional status correctly could be the biggest tax saving strategy for them each and every year.
Real Estate Professional Tax Status Myths
There are a number of myths about the real estate professional tax status. Don’t be fooled—or file your taxes incorrectly.
Myth #1: Everyone involved in real estate should be a real estate professional.
No, this is incorrect. The real estate professional status is only important to people who own rental properties. So if your real estate activities only consist of flipping or wholesaling, then you do not need to worry. Any net losses can generally offset other income without limitations.
Myth #2: If I own rentals, I will always benefit from being a real estate professional.
This is also incorrect. Owning rental properties doesn’t necessarily mean that you need to qualify as a real estate professional in order to get your deductions. You can always use your expenses and depreciation to offset rental income. Being a real estate professional is only important if you have a net loss on your rental properties which is limited by a higher yearly income.
Myth #3: LLCs can be considered real estate professionals.
Real estate professional tax status is only determined by the person involved in the real estate. You need to show that you personally spent more than 2,000 hours per year on rental activities. The fact that your LLC only does rental activities doesn’t help you personally become a real estate professional. Having an LLC is a good idea for asset protection purposes. But it won’t help you get around the hours requirement for being a real estate professional.
Myth #4: If I get my real estate license, I become a real estate professional.
Since real estate professional status is only an IRS rule, it really does not matter what licenses you hold with the state.
Myth #5: I must be a real estate professional each and every year.
Contrary to popular belief, real estate professional status is not a one-time test—it’s actually a year-by-year designation. It is possible (and common) for investors to claim real estate professional tax status in one year and not the next.
Myth #6: To claim this designation, I simply list my occupation on the tax return as real estate professional.
For those of you claiming real estate professional status, yes, it is important to make sure that you list your occupation on the tax return to be as such. But don’t forget to make an election to aggregate your rental real estate if you own multiple properties.
Myth #7: I must be a real estate professional in order to take a home office deduction.
This is another common but incorrect assumption. Regardless of real estate professional status, ordinary and necessary business expenses are generally tax deductible. As long as you have a qualified home office, it is possible to claim the home office deduction each year regardless of whether you are a real estate professional or not.
Tax time is almost here. The real estate professional status isn’t the only strategy you can use to keep more of your investment income! To learn even more about all the ways you can slash your taxes as a real estate investor, pick up The Book on Advanced Tax Strategies from the BiggerPockets Bookstore.
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