Commercial Real Estate

Want to Pay Less in Taxes? You Need This Designation (& May Already Qualify!)

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1031-exchange

Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation.

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For those starting out in real estate investing, you may or may not have heard of the real estate professional (REP) designation. If you’re a seasoned vet, you’ve probably heard of this advantageous tax classification and are perhaps even already taking advantage of it!

There’s a good amount of information out there on what a REP designation is and who can qualify. However, for the sake of this blog post, I am going to go a little deeper and talk about how a REP designation affects cost segregation “losses.”

Whether you qualify or not, it is important for you to understand how cost segregation and the REP designation can go hand in hand. After all, as your portfolio increases (which I assume is your ultimate goal), so will your likelihood of being able to effectively use cost segregation as a REP.

For those who want a recap of what the REP designation entails, check out the next section. But if you already know what it’s about, skip to “The Real Estate Professional & Cost Segregation.”

Realtor showing house to a young couple wanting to rent it

What is a Real Estate Professional Designation?

REP is an IRS tax classification designed for those who work a certain number of hours each year within the real estate business. Having the REP designation is advantageous because you can deduct all depreciation and losses against income reported on your 1040.

Imagine the amount you can save on taxes as a REP! (If you don’t have the best imagination, I can tell you it’s a lot.)

On the flip side, those without a REP designation cannot deduct depreciation and losses from their ordinary income. For example, if Joe the investor owns three single family residences, is a W-2 employee, and does not qualify as a REP by the IRS’s standard, he cannot deduct his rental properties’ depreciation and losses against his W-2 income.

Related: The Ultimate Guide to Real Estate Taxes & Deductions

How to Qualify as a Real Estate Professional

In order to qualify as a REP, you must:

  1. Spend more than half your work time in a real estate business or businesses.
    • Activities may include (but are not limited to) redevelopment, leasing, acquisition, construction, operation, leasing, and rental.
  2. Work at least 750 hours for that business or those businesses.

Other tips and tricks to qualify:

  • If you’re married and either you or your spouse qualifies as a REP, whoever has the designation can use those losses to offset W-2 income.
  • If you own more than one real estate business, it is highly recommended to combine the businesses into one entity to satisfy the 750-hour rule. If not, you would be expected to spend 750 hours on each business. (Ain’t nobody got time for that!)

Real estate agent handing the house key

The Real Estate Professional & Cost Segregation

Cost segregation is a tax planning strategy used by smart real estate investors to accelerate depreciation on certain components of a property, in return lowering tax liability.

So where does cost segregation and REP come into play?

As I stated above, cost segregation reduces tax liability by using the depreciation captured as a written loss on your taxes. Cost segregation losses are considered passive losses (real estate losses) and can only be used to offset passive income. However, if you are a REP, you can use cost segregation’s losses against ordinary income!

Related: Why Real Estate Investors Need to Pay Attention to Cost Segregation

[ Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisor regarding your specific situation. ]

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Want to learn how you could be saving more on your real estate taxes using loopholes, deductions, and more? Get the inside scoop from Amanda Han and Matthew MacFarland, real estate investors and CPAs, in Tax Strategies for the Savvy Real Estate Investor. Pick up your copy from the BiggerPockets bookstore today!

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Anything else I can answer about the REP designation or cost segregation?

Ask me in the comment section. 

Mary is a Marketing Manager for a cost segregation software solution, Titan Echo (www.titanecho.com), located in BiggerPockets' hometown - Denver, Colorado! Mary was first introduced to the world o...
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    Eddie Daniel
    Replied over 1 year ago
    Thank you for this article Mary. It seems like almost every article I read ignores REP designation when talking about deducting losses. Many newbies invest in real estate assuming that all losses are deductible against their W-2 income and don’t give it a second thought by investigating the details. I wonder if you could comment on the “Special $25,000 Allowance” section of IRS Publication 925, as it pertains to this topic. It seems to be a way to deduct losses against W-2 income as long as your income is not over certain limits and you “actively participate” (Less stringent rules) in the business. I’m just trying to figure out if all the small investors that I know are unknowingly claiming illegal deductions against their W-2 income on their taxes every year or if they have a loophole here that allows them to do it legally. Thanks again!
    John Woodrich Flipper/Rehabber from Minneapolis, MN
    Replied over 1 year ago
    They can generally deduct up to $25k if they are single and their income is under $125k or married with household income under $150k. If they were not claiming it correctly it would be easy for the IRS to track.
    Rick Klopp from North GA
    Replied over 1 year ago
    IRS Pub 925 states that if you are a REP, then your activities are not considered passive. How does that work against Schedule C and E on form 1040. Thanks for bringing this topic back up again. Following along.
    John Woodrich Flipper/Rehabber from Minneapolis, MN
    Replied over 1 year ago
    Still report on Sch-E if it is a rental.
    Aaron Brown Rental Property Investor from Independence, MO
    Replied over 1 year ago
    How does being designated as a real estate professional affect your schedule e rental income? If you claim your schedule e income as active income(as a REP), wouldn’t you have to pay self-employment taxes on the rental income? I had always understood that as the downside of designation as a REP. Also, what if you have schedule e rental income, and are also a licensed real estate agent? Could just your commissions and income from being an agent be classified as REP income, AND AVOID your schedule e rental income from being taxed extra? Good info for discussion!
    Aaron Brown Rental Property Investor from Independence, MO
    Replied over 1 year ago
    How does being designated as a real estate professional affect your schedule e rental income? If you claim your schedule e income as active income(as a REP), wouldn’t you have to pay self-employment taxes on the rental income? I had always understood that as the downside of designation as a REP. Also, what if you have schedule e rental income, and are also a licensed real estate agent? Could just your commissions and income from being an agent be classified as REP income, AND AVOID your schedule e rental income from being taxed extra? Good info for discussion!
    James Gorman IV Investor from Gig Harbor, Washington
    Replied over 1 year ago
    I’m a Real Estate Professional, and a professional engineer in several state and in DC. (THE SWAMP) The solution is to read & re-read & re-re-read IRS Pub 925 and give the IRS auditors smart pills if possible. I also suggest learning about the opportunities offered by IRS 721, 1031 & 1033 EXCHANGES. Deferral of taxes & expenses in RE investing is So-so-important especially if you do not want to pay a big 25 to 38% tax currently on a RE income property sale.
    Kathleen J. Real Estate Agent from Naperville, IL
    Replied 12 months ago
    So I qualify as a REP, but my spouse does not. Our understanding was that for married filing jointly only 1 of us has to qualify for REP status for us to both benefit, but are you saying that the losses can only be deducted from MY W2 earnings, not his too?