For investors who are also high income earners, the real estate professional status is undoubtedly one of the most powerful tax tools that can potentially help someone bring their tax bill from 35% down to 15% or lower. A while back, I wrote a blog post about all the wonderful tax benefits of being a real estate professional called “Your Complete Guide to the Real Estate Professional Tax Loophole.”
I received quite a few questions on that topic and also noticed there was a lot of misinformation floating around out there. This week I wanted to talk about 7 common myths regarding the real estate professional status.
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7 Myths About the Real Estate Professional Tax Status, Debunked
Myth #1: Being a real estate professional is important for everyone involved in real estate.
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 real estate or wholesaling real estate, then you do not need to worry about being a real estate professional, as any net losses can generally be used to offset other income without limitations. This means that you do not need to prove you spend a certain number of hours in your flipping activities as you would otherwise need to if you were a landlord.
Myth #2: If I own rentals, I will always benefit from being a real estate professional.
This is also incorrect. If you own rental properties, this does not necessarily mean that you need to qualify as a real estate professional in order to get your deductions. In fact, whether you qualify as a real estate professional or not, 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 are limited as a result of higher income for a particular year.
Myth #3: LLCs can be real estate professionals.
From time to time, I come across investors who have been told that using an LLC can help them become a real estate professional. Unfortunately, this is incorrect, as real estate professional status is only determined by the person involved in the real estate. For example, if you work 2,000 hours a year at your job and you have an LLC that is formed to only hold your rental properties, you still need to show that you personally spent more than 2,000 hours per year on rental activities. The fact that all your LLC does is rental activities does not help you to personally become a real estate professional. Having an LLC is a good idea for asset protection purposes, but keep in mind it does not help you get around the hours requirement for being a real estate professional.
In short, LLCs and other types of legal entities cannot be real estate professionals; only you as the individual investor can attempt to qualify for that designation.
Myth #4: If I get my license in real estate, I become a real estate professional.
This is also a common misconception that I hear from time to time. Since real estate professional status is only a rule in the tax world, it really does not matter what licenses you hold with the state. Let’s look at two examples to illustrate this point. Jamie is a long time real estate investor. She owns close to a dozen properties and manages most of them herself. Jamie retired from her full time job as a teacher many years ago and now spends most of her time on her rental properties. Although Jamie never obtained her license to be a real estate agent or real estate broker, Jamie was able to qualify as real estate professional because she spent more than 750 hours in real estate and she spent more time in real estate as compared to her job. For Jamie, it was easy for her to qualify that she spent more time in real estate as compared to her job because she simply did not have another job.
Let’s go over a difference scenario.
Becky wanted to get into the real estate business. She owns one rental out of town that is managed by a property manager. Becky has been very fortunate in that her property is fairly hassle-free and she is able to spend very little time on it. Becky decided to become a real estate agent and spent some time to obtain her license. After obtaining her real estate agent license, Becky got employed by a broker as a full-time employee. Becky spends most of her time working as an employee for this broker. In this scenario, although Becky obtained her real estate agent license, it does not automatically mean Becky is a real estate professional. Since Becky has a W-2 job, Becky must be able to show that she spends more than 750 hours materially participating in her out of town rental and that she spends more time on her own rental than her W-2 job. As such, if Becky works 2,100 hours at her full time job, then she must be able to prove that she spent more than 2,100 hours on her rental property in order to qualify as a real estate professional.
Now here is a little twist. In the same example above, if Becky was hired by the broker as a 1099 contractor instead of a W-2 employee, then it may be easier for her to qualify as real estate professional. For those of you who are both real estate agents and investors, make sure to strategize with your tax advisor on which route makes the most sense for you in terms of tax savings.
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 and is actually a year by year designation. It is possible (and common) for investors to claim real estate professional in one year and not the next.
Take the example of Mary. Mary was a full-time nurse and part-time real estate investor. She decided to take a few years off from her nursing career to stay at home and take care of her elderly mother. During those years, she spent a lot of time on her rental properties and was able to claim real estate professional status. A few years later, Mary went back to work full-time as a nurse after her mother’s health recovered. After going back to work, Mary was no longer able to show that she spent more time in real estate as compared to her job, so she stopped claiming real estate professional status.
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, it is important to make sure that you list your occupation on the tax return to be as such. I often see investors claim to be real estate professionals on their taxes while indicating on the tax return that they occupation is something different. Although labeling your occupation as real estate professional can help to minimize audit risk, there are more actions that need to be taken on the actual return to document this designation.
For those of you who own multiple rental properties, it is important to make an election to aggregate your rental real estate as one activity. By doing so, you are telling the IRS that instead of spending 750 hours of material participation on each of your rentals, you are combining them into one single activity so that the 750-hour threshold is only required for all your rentals as one unit. Unfortunately, the election is not a simple box to check on the tax return nor a specific form to be filled out. It is a separate election language that is attached to your tax return. An example of this should 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).”
Myth #7: I must be a real estate professional in order to take a home office.
This is another common but incorrect assumption. One important thing to note is that regardless of real estate professional status, business expenses that are ordinary and necessary for your real estate business are generally tax deductible items. In the example of a home office, 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.
Check out my article on “3 Reasons You Should Love the Home Office Tax Deduction.”
The same goes for travel costs, real estate education, computer expenses, and so on. Make sure you claim all your legitimate real estate-related expenses. Even if an expense is limited in a particular year due to higher income thresholds, those expenses can generally be carried forward into future years to offset future taxable income.
For more information on entities and tax strategies, check out Amanda’s book The Book on Tax Strategies for the Savvy Real Estate Investor.
Investors: Have any questions about the real estate professional status? Any myths you’d add to this list?
Leave your comments below!