How to Avoid the #1 Most Common and Costly Tax Mistake as a Real Estate Investor

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For anyone who filed an extension, this is the time of the year you are thinking about taxes again. It is scary to think that the average American loses more money to taxes each year than we do on food, clothing, and shelter COMBINED.  As scary as that sounds, there is a silver-lining to all this: As a real estate investor, you have the ability to control when and how much you pay to Uncle Sam. However, the tax benefits that are available to real estate investors do not “automatically” help you to save taxes. In fact, over the past decade, I have reviewed countless tax returns that cost investors thousands to tens of thousands of dollars in overpaid taxes because neither they nor their tax preparers know “how” to take advantage of all the real estate tax loopholes. As we head into the 2012 extension tax deadline, I wanted to take the opportunity to share with you the #1 Most Common and Costly Tax Mistake that you need to know as a real estate investor.

If you are a real estate investor, you must understand the Real Estate Professional Status and take advantage of the all the wonderful tax benefits relating to your investments. [Caution: Even if you have heard of the real estate professional status before…keep reading as you may be surprised to learn something new!] The “real estate professional status” loophole is what we see time and time again that helps taxpayers to decrease their taxes from tens of thousands of dollars down to ZERO. The reason that you want to qualify for the real estate professional status is because without the real estate professional status, your ability to actually benefit from your real estate tax deductions may be limited.  As a real estate professional, however, you get to take advantage of an unlimited amount of real estate deductions each year on your tax return.

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Real Estate Professional Status, What is it?

So what exactly is this real estate professional loophole and how can you take advantage of it? Well, real estate professional, as defined by the IRS, actually has nothing to do with whether you are a licensed real estate agent or broker in your state. 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 set of different criteria. Simply put, the taxpayer (or spouse) only needs to meet both of the two following criteria in order to qualify for the tax benefits of being a real estate professional:

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.

What You Need to Know to Benefit

Sounds easy enough? You may be shocked to learn that this simple tax loophole is by far the biggest and most common mistake that I see time and time again made by real estate investors. Let me share with you an example of someone I spoke with just last week.  Lynne has been working with a CPA for many many years and was always told she has been benefiting from the tax deductions as a real estate professional. When I reviewed her tax return, I had to be the bearer of bad new and let her know that her CPA prepared her taxes wrong and she lost out on $21,000 of a tax refund. The worst part of this was that there was nothing I could do after the fact to get that money back for her. Contrary to popular belief, the real estate professional status is not taken by simply indicating “real estate professional” as your occupation on page 2 of your tax return. It is also not a specific form to fill out with your tax return. To make things even more complicated, it is not even a particular box to check. Rather, it is an election that must be attached to your tax return at the time you file it. If you invest in real estate, make sure you speak to your tax preparer to ensure that election is in place before you send off that tax return.

The Good and Bad

The good news is: The average tax savings between a real estate professional and someone who is not a real estate professional is anywhere between $10,000 to $35,000 each and every year! The bad news is: if you make a mistake, it cannot be undone. The appropriate tax election must be attached to your original tax return at the time you file it…no amendments, no exceptions!

What Action Can Be Taken?

If you are a real estate investor and you have not spoken to your tax advisor about the benefits of this amazing loophole, you are probably overpaying your taxes. Contact your tax advisor TODAY to find out how you can plan ahead to take advantage of this powerful opportunity and start to save some significant tax dollars year after year!

About Author

Amanda Han

Amanda Han of Keystone CPA is a tax strategist who specializes in creating cutting-edge tax saving strategies for real estate investors. As real estate investors herself, Amanda has an in-depth understanding of the various aspects of investing including taxation, self-directed investing, entity structuring, and money-raising.

36 Comments

    • Hi Amie:

      Even if you do real estate on the “side” it is still a potential benefit for you as long as you meet the hours requirement. I would definitely suggest that you speak with your tax advisor to strategize on whether that is a possibility for you.

  1. Great article, Amanda.

    Spend more time in real estate activities than other “non-real estate” business activities combined

    How would the IRS go about confirming your claim if they did audit you? Any tips on that would be great.

    • Hi Sharon:

      See Nikky’s comment below. Basically, it is an honor system so you do not need to submit your hours unless if you are audited. For best practice I would suggest that you keep a log (excel, book, calendar) that shows what you did, date, what property it relates to, etc. Also, any outside/third party documentation such as emails, call logs, business cards, etc. is always a plus. Checkout our website as we have a Real Estate Professional Status Essential Toolkit that you may find helpful.

  2. Sharon, the 750 hours a year rule with more time dedicated to real estate is tough if you are not a “full-time” real estate professional and do real estate as a p/t job while carrying on another career. However, if you are like me, I only work part-time teaching while trying to build our real estate portfolio for long-term investment and short-term tax benefits. Document all your hours spent in a spreadsheet on a daily basis as you do it. You’ll need a little over 14 hours a week… but you’ll get those hours quickly by “educating” yourself on the market (reading blogs like this!), researching your market, dealing with your current properties, driving by potential or current properties, etc… just start documenting so if you are ever audited, you are protected!

    I just found this website and I love it! Thank you!

    • Nikky, is it really true you can accumulate those hours by educating yourself? If that’s the case then could you earn those hours by working in a related field such as construction?

  3. Michael Woodward on

    Awesome advice Amanda! I don’t know nearly enough about taxes so this kind of information is very valuable. I did a little digging through the IRS website about this to try to learn more about it. Does it only apply to people that deal with rental properties or would it also work for a fix-and-flip person? Thanks! Mike

    • Hi Mike:

      This is mainly relevant to rental real estate. As a flipper, you do not need to worry about real estate professional as you are always able to fully deduct your expenses relating to a flip property in the year of the sale…no limitations.

      • I think that the question would be for those that own rentals and also generate income via real estate from non-rental activities like flipping and wholesaling how would it work.
        Would time spent working in your other real estate business (Be it a S-Corp, LP, LLC, sole proprietorship or what not) count towards your total? Maybe even more important would they count AGAINST you as in if you spent 1500 hours marketing, acquiring, managing and then selling rehabs does that mean you would need to document 1501 hours working on your rentals?
        The goal for people doing both is of course to be able to shelter some of your income form active real estate activities with your passive real estate losses. This will really only work if you are an RE Pro since it doesn’t take too much success as a flipper to blow past the phase out limit on that $25K.

        Also to confuse the hell out of people that are just learning this stuff I am NOT a dealer. In my case I had a 5 year track record as a rental property owner before I ever did a flip. Since I stared doing flips I have acquired many additional rental units as well. So I am a passive investor that sometimes flips a property that doesn’t meet my long term criteria and then I will use that capital to buy a rental that does.
        (How does that sound? It is my “elevator pitch” if I ever get audited 🙂 )

        • Amanda Han

          Hi Shaun:

          You are right…the tax code definitely confuses people more than is necessary. To answer your question, your time doing flipping, marketing, wholesaling, etc. generally will count as REP course so it actually works in your favor. We is, of course, assuming that you are doing these for yourself and not as an employee of someone else (there is a set of different rules to look at when you are working for someone else as a w-2 in these types of activities).

          We have a lot of clients that have your exact profile. People tend to do all types of real estate transactions…depending on what is best for that particular deal. The good thing with respect to the tax rules is that it is deal specific. So in your case, it is definitely possible to be passive with respect to some activities, non-passive to some activities, and active with others. At the end of the day…it comes down to intent and it is definitely possible that intent changes from time to time if you get a rental property that gets sold prematurely because of changes in the market or your investment strategy.

  4. gwen trotter on

    Thank you Amanda for that awesome advice. Now if I could only find “The Right CPA” in my hometown. Would you have any advice how I can find one. I’ve asked at my REI Club and so far their CPA’s are 50+ miles from me(Indiana vs Illinois). Surely, there’s got to be someone closer but I don’t know how to find them. But I’ll keep asking.

    • Hi Gwen:

      I would just say to keep trying. We have clients all over the US and a lot of them tell us that they feel they meet and strategize with us a lot more often than they ever did with a local CPA. Before you work with someone outside of your local area you need to first see if you are comfortable working in a remote setting (ie: conference call, email, Skype).

  5. 1) Spend more time in real estate activities than other “non-real estate” business activities combined.

    Is this verified from gross income? How would an auditor verify your status if, for example, you are self-employed in a non-real estate field where you spend a good deal of of your time, but your other business (rentals or flips) generates more income than the other job.

    Curious how this is verified. Thanks for giving me something to think about.

    • Hi Page

      See my response to Sharon above. Essentially, it is a log that you would keep to track your hours of real estate vs. non-real estate activities. The income you make on one activity vs the next one does not matter in this analysis.

  6. Amanda – are you sure an amendment cannot be made? For the 2009 tax year my preparer at the time did not claim the real estate professional status, among a host of other errors. In 2010 I took my business to a real CPA with the appropriate RE experience and the first thing he did was amend my 2009 return and I was able to receive a decent refund from that year. Wondering why and where in the IRC does it say you cannont file a 1040x amended return and claim RE Professional status retroactively?

    I agree this is a powerful “loophole” which allows you to claim passive losses beyond the standard $25k with no phase outs. It also allows you to deduct RE losses against non passive income which is huge for investors where one spouse holds down a day job.

    • Hi Serge:

      The amendment can be made…the real question is whether you had the election to aggregate your real estate activities. Up until as recent as last year, the IRS did not allow for late elections to aggregate real estate to be filed and those had to be filed with the original return. Good news is that this is now allowable in certain instances. So for you…I would just cross my fingers and hope that your return doesnt get audited and after three years you are free and clear!

  7. I am more interested in the second qualifier, that of 750 hours in REI.
    I would say it is possible to log that many hours, and still work my hvac trade more hours.
    Would I qualify only on the 750 hours?

    • Hi Dennis:

      Unfortunately..you must meet both requirements. So if you work 1,000 hours, then you must have over 1,000 hours to qualify as real estate professional. If you work 600 hours, then you only need 750 hours.

  8. Toby Johnston on

    In my professional experience it is sometimes easier said than done to qualify for this status. If you have a full time non real estate day job, it is very difficult. A full time job means 2,000 hours per year to the IRS. So you then need to show them that you worked as a real estate pro for more than 2,000 hours. On audit you must be able to show that you meet the hours requirement. The best way to do this is to keep a contemporaneous log of your hours worked with dates and activity descriptions. So it becomes very tedious.

    At the low income end you still have the $25K exception to the passive loss limitations. At the higher end, just remember that you are not permanently losing deductions but merely accumulating them as a suspended passive loss until you sell or generate other passive income. So it is a timing difference. Finally, it is only really an issue for rentals which generate depreciation deductions. So for flippers and wholesellers it is not an issue unless they also have rentals.

  9. Looking at the comments – a couple observations (I am a tax attorney). First, you must satisfy both criteria – not just one. So both (1) Spend more time in real estate activities than other “non-real estate” business activities combined AND (2) Spend at least 750 hours per year in real estate activities.

    The hard part about meeting this test is the first requirement. It is a time requirement, not an income requirement (income is irrelevant). You will need to document the time spent on the activity, which you can do using ‘any reasonable method,’ including through use of appointment books, calendars, or narrative summaries. But taxpayer’s oral testimony alone isn’t a “reasonable means” of establishing the numbers of hours of services performed in real property trades or businesses.

    Much more importantly though, it will be nearly impossible for someone with a full-time job to claim this exemption since they are probably working 40 hours a week already at their ‘primary’ job – substantial evidence will be necessary. Moreover, an even more common trap is for those people in the real estate industry (brokers, lenders, private equity employees, etc.) – time spent at those job does not qualify for the 51% test UNLESS the employee is a 5-percent or greater owner in the employer.

    The moral of the story here is – the election is much more narrow than alluded to above. However, if you do qualify, you should consider ‘grouping’ your real estate activities so that the time spent on all the activities are combined or else time spent on each will not be aggregated. There are adverse consequences of this grouping (i.e., acceleration of deferred losses), so you should consult your accountant about these.

  10. reading this article, It just tells me a simpler tax method is needed (probably not happening anytime soon).
    @JAY would educating yourself to acquire skill sets be considered as part of the 750 hours? by that I mean spending time reading articles, reports, blogs like these? and is so how would one document them if not an oral manner?

    IF one spends time documenting the 750 hours, that seems too tedious, probably like another full time job. and if the reason to show logs is to have evidence “if ever audited” just shows something is seriously wrong with the tax system.

  11. @Danny and others, two points.

    First, I would not try to rely on reading blogs and education to try to meet your 750 hour requirement, the technical rule reads: “such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.” That is 750 hours of services, not just spent on real estate. Though not definitive and you should consult your own advisor, if you are relying on that to meet the requirement, you are probably not a ‘real estate professional’ as defined.

    Second, I disagree with your statement that ‘there is something wrong with the tax system’ in this instance. This rule provides extremely advantageous tax treatment to those persons that qualify. The provision is only for those whose main line of business consists of rental real estate activity. If someone is trying to pigeon-hole themselves into qualifying for this provision, they are very likely NOT a real estate professional as defined in the Code. As I stated in my earlier post, the 51% of the time on real estate activities is the much harder test to meet. If someone can satisfy that test, I would think meeting the 750 hours test would be a piece of cake. If someone is struggling to hit 750 hours and thinks documenting the 750 hours is too burdensome, it likely follows that the Code provision does not apply to you.

  12. Raquel Baranow on

    Would a RE professional take deductions on Schedule C or A?

    All the CPAs I’ve talked to say I should take my deductions on Schedule A.

    All my income is from RE investments and rental but I wonder if I work 750-hours a year at it.

    • Hi Raquel

      Rental real estate should be on Schedule E. Active real estate should be on Schedule C. Generally Schedule A is the least preferred place to take write offs so I would seek another opinion in your scenario.

  13. I would definitely love to take advantage of this loophole if my earned income wasn’t part of a full-time job that I work 40-hr/wk and while I p/t REI. I will in due time though

  14. Also, @Amanda, what election are you referring to? Is it the election to treat all rental activities as a single activity? I don’t believe there is an election to be treated as a real estate professional.

    • Hi Jay:

      Yes…see my post above. This is the election to aggregate which I believe you detailed above. Unfortunately too many taxpayers claim real estate professional but neglect to aggregate and that has caused the RE deductions to be disallowed time and time again.

      • I have no idea what Jay and you are referring to when you talk about “aggregating” and “grouping.” That concept was not presented in the original blog and I am not able to understand the importance of it from your brief comments back and forth with each other. Can you please elaborate and give an example, perhaps? Thank you.

        • Hi Sharon

          No problem. The time rule of being a real estate professional of 750 and more than 50% of time in RE vs non-real estate activities is a “per property” requirement. So this means that if you own two properties and assuming you dont have another job, then you would need to have 750×2=1,500 hours to be a REP. The election is a way for you to bypass that requirement and treat both rentals as one property…this way, you would still only need 750 hours and not 1,500 hours to qualify as REP.

    • Hi Aaron:

      Unfortunately I do not know of anyone in that area but we do help clients all over the US! Otherwise, I suggest that you ask around your local REIA to see who are some local CPAs that specialize in working with investors. A recommendation is worth a thousand words.

  15. I think the most important item is being glossed over here:

    -Buy rental property that should cash flow positive, depreciate it (or put money into it to fix it up) and reduce your tax liability for other income (such as marketing houses as a broker/agent).

    What I would like to see if a formula to use to know exactly how much rental property one needs to buy each year on what depreciation schedule vs X income to maximize the real estate professional status tax benefits.

    I suppose you have to find a good real estate CPA for that.

  16. Amanda is the $25,000 a per year limit for showing a loss or for something else? I used to routinely show a loss of $3 or $4,000 per year in my real estate investment company but that is now changing and I am showing a profit.

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