Real estate investing offers an outstanding path to long-term wealth. However, a lot of confusion exists when it comes to real estate and taxes.
New investors hear that real estate provides great tax advantages, but they don’t necessarily know-how. Things get even more complicated when you consider real estate professional status. The IRS formally designates some investors as “real estate professionals.” This status provides tremendous tax benefits.
However, just because you own a rental property doesn’t mean you qualify as a real estate professional. You must first meet certain clear IRS requirements. As such, we’ll use this article to explain the IRS real estate professional status. We want you to clearly understand the benefits and who does–and does not–qualify. Specifically, we’ll cover the following topics:
- What Does it Mean to Be a Real Estate Professional?
- What is Real Estate Professional Tax Status?
- Different Types of Real Estate Investors
- Should I Become a Real Estate Professional?
- How to Qualify as a Real Estate Professional
- How to Manage Real Estate Professional Taxes
- Takeaways: Becoming a Real Estate Professional
What Does it Mean to Be a Real Estate Professional?
Real estate professional is a formal IRS tax classification. It is not anyone who works in the real estate industry. Rather, individuals must meet detailed IRS criteria to qualify as a real estate professional. But, if you do qualify, you gain tremendous tax advantages.
Typically, individuals cannot use losses from passive activities to offset ordinary income on their taxes. For example, you generally cannot use real estate losses to offset W-2 wages. The IRS calls this restriction a passive activity loss (PAL) limitation.
An exception we’ll discuss below exists for people with modified adjusted gross income (AGI) less than $100,000. In certain situations, these taxpayers can deduct up to $25,000 in real estate losses. This allowance completed phases out at $150,000, though.
On the other hand, real estate professionals face no deduction limitations. Instead, with this classification, the IRS considers your real estate income nonpassive. This means that you can deduct all of your real estate losses, regardless of income level.
What is Real Estate Professional Tax Status?
As stated, real estate investing generally qualifies as a passive activity. However, the IRS offers an exception to this rule. If you qualify as a real estate professional, the IRS grants you a special real estate professional tax status.
With this status, the IRS no longer considers your rental real estate activities passive. As such, you can deduct all losses from these activities.
For example, assume you qualify as a real estate professional with $175,000 in modified AGI. Additionally, you own three rental properties that generate $40,000 in total losses.
Normally, the IRS would not let you deduct any of those rental losses. However, as a real estate professional, you can deduct the entire $40,000 amount on your taxes.
Real Estate Professional Criteria
To qualify for this advantageous tax treatment, you need to meet both of the following criteria during the year:
- More than half of the personal services you performed in all trades or business during the year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
NOTE: The IRS offers seven different tests to determine material participation. Most investors meet this requirement by participating in an activity for at least 500 hours.
In simple terms, the IRS wants to confirm two items before calling you a real estate professional. First, you spend the majority of your time providing personal services doing so in the real estate industry.
The IRS considers wages, salaries, and self-employment income personal service income. Second, you spend at least 750 hours actually performing these real estate personal services.
It’s important to note that the real estate professional tax status applies to individuals, not businesses. This includes married filing jointly taxpayers, as well. Yet, in the case of couples, both spouses do not need to meet the above criteria.
Different Types of Real Estate Investors
To better understand real estate professional status, it helps to see how the IRS views real estate investors. The IRS differentiates between real estate dealers and investors. Whereas dealers primarily focus on reselling real estate, investors focus on investing in real estate. For instance, buying a property to rent falls into the investing category.
As you may expect, this distinction has major tax implications. Importantly, investors can depreciate property and do not pay self-employment taxes. Real estate dealers do not depreciate their properties and generally must pay self-employment taxes. As such, real estate investor classification can save you a lot of money at tax time.
To further complicate things, the IRS classifies different types of real estate investors. Broadly speaking, three types of investors exist. We’ll discuss these from most beneficial to least beneficial from a tax perspective.
Real Estate Professional
As stated, this IRS status provides investors the most tax benefits. Real estate professionals can deduct all of their real estate investment losses, regardless of income level. However, due to these tremendous advantages, this category has the strictest qualification criteria.
Active real estate investors gain some tax benefits from the IRS, but not as many as real estate professionals. To qualify as an active investor, you need to actively participate in your real estate investments. Active participation is a lower IRS threshold than material participation, which is required for real estate professionals.
According to the IRS, you actively participate if you make management decisions in a significant and bona fide sense. Management decisions that qualify as active participation include approving tenants, setting rental terms, approving expenses, and similar decisions. Most people who own rental properties make these decisions and qualify for active participation.
Active investors can potentially deduct up to $25,000 in real estate investment losses against your ordinary income. This is an exception because passive losses can typically only offset passive income. To figure out if you qualify for this $25,000 allowance, the IRS uses a figure known as modified AGI. The calculations for this number can become fairly complicated.
Say you have modified AGI less than $100,000. You could deduct up to $25,000 in passive real estate losses against ordinary income (e.g. salaries, wages).
But, with a modified AGI greater than $150,000, you can’t deduct any passive losses. In between these amounts, the allowable passive activity losses gradually phase out. At $125,000 in modified AGI, you could deduct $12,500 in passive losses ($25,000 / 2).
Passive real estate investors receive the fewest tax benefits. These investors do not actively participate in their real estate investments, and they can only deduct passive losses against passive income.
According to the IRS, passive income includes the income earned from rents, royalties, and limited partnership stakes. On the other hand, earned, or ordinary, income generally includes wages, salaries, and income from running a business.
As a limited investor, you can only use your real estate investment losses to offset other passive income. For example, a $10,000 loss on rental property could offset $10,000 in income from book royalties, but you could not use any of this $10,000 loss to offset wages or other earned income.
Should I Become a Real Estate Professional?
Clearly, tremendous tax benefits exist for real estate professionals, but this doesn’t mean that everyone should pursue this IRS status. Before making a decision, consider the below scenarios.
When You Should Become a Real Estate Professional
Here are a few scenarios when investors would benefit from the real estate professional status:
You own rental real estate:
Real estate professional status provides tax benefits for real estate investments. So, if you have multiple rental properties, you stand to gain significant tax advantages as a real estate professional.
No other full-time job:
Without another full-time job, you’ll find it easier to meet the real estate professional qualification criteria. Any personal services you provide in the real estate industry will also be your only personal services.
As such, you’ll just need to hit the 750-hour minimum.
Spouse has a large salary:
If your spouse makes more than $150,000 in earned income, you won’t qualify for the $25,000 passive loss allowance.
Consequently, you wouldn’t be able to deduct any losses from rental properties. Real estate professionals could A) deduct all real estate investment losses, and B) help offset the spouse’s salary.
When You Should NOT Become a Real Estate Professional
Your personal services don’t qualify:
Real estate personal services as an employee generally don’t count towards real estate professional requirements.
Unless you own 5% or more of your employer, you can’t count this work towards IRS criteria.
You own limited real estate:
If you only own a single rental property, the efforts may not be worth it. Real estate professional benefits involve real estate investment losses.
Realistically, a single property may not generate enough losses to justify pursuing this designation.
How to Qualify as a Real Estate Professional
To qualify as a real estate professional, you need to do a couple of things. First, you must actually meet the IRS requirements. Second, you need to maintain documentation proving that you meet those requirements in case of an audit.
Meet the Requirements
As stated, taxpayers must meet two criteria to become a real estate professional. We’ll provide some amplifying information here.
More than 50% of personal services in the real estate industry:
This means that more than half of your annual working hours need to be in the real estate industry. This automatically disqualifies most people with full-time jobs.
For example, say you work 2,000 hours per year as an accountant not in the real estate industry. You would need to materially participate for at least 2,001 hours on top of that in real estate.
At least 750 hours worked in the real estate industry:
These hours include work in the real estate industry. As such, investment activities like researching listings do not count.
Additionally, by default, the IRS treats each rental property as a separate activity. That means you would need to work 750 hours on each property to qualify.
Fortunately, the IRS allows you to elect to treat all properties as a single activity.
With this election, 100 hours spent working on ten different rentals would total 1,000 hours.
Keep Track of Your Documents
Due to the tremendous tax advantages, the IRS wants to ensure you actually qualify as a real estate professional. For enforcement purposes, the IRS will periodically conduct an audit of your real estate documentation.
As a result, it is critical that you maintain an accounting of your hours worked. Specifically, you’ll need supporting documentation to prove you worked 750 hours and met the greater than 50% requirement.
You can do this by clearly documenting your time working in real estate and what you were actually doing. This is especially important for investors with jobs in industries outside of the real estate world.
How to Manage Real Estate Professional Taxes
As with any tax issues, real estate professionals need to stay organized. Multiple techniques exist to organize your real estate income, expenses, and other tax-related matters. Some people use Excel spreadsheets.
Others use expensive real estate tax software. Bottom line, whatever technique you choose, successfully managing your real estate taxes requires organization. Here are a few tips:
Track income and expenses by property:
When you file your annual tax return, you report rental activities on Schedule E. And, you report income and expenses by each property on this form.
If you commingle maintenance expenses for all your properties, accurately filling out your Schedule E by each property will be a nightmare.
Keep your receipts
If you’re going to deduct an expense, make sure you have the receipt to support it. This will protect you in case of an audit. It helps to organize digital folders by property and by year.
For example, if you buy maintenance materials, you should simply save the receipt to the “123 Main St (2020)” folder. Then, in case of an audit, you know exactly where to find all of your receipts.
Don’t elect if you can’t prove
As stated, the IRS may audit you if you claim real estate professional status. If you can’t document that you’ve met the requirements, don’t make this election.
You could face interest, penalties, and, if fraudulent, potentially prosecution.
Most real estate activities generate losses due to depreciation, but you’ll also eventually need to pay depreciation recapture taxes.
The IRS will impose these recapture taxes regardless of whether you actually claimed allowable depreciation every year.
Don’t waste this tax benefit! Make sure you understand depreciation schedules to minimize your annual tax liability.
Takeaways: Becoming a Real Estate Professional
If you meet IRS criteria, real estate professional status provides outstanding tax advantages. However, we also understand how confusing taxes can be for real estate investors.
Don’t let this confusion stop you from saving a ton of money at tax time. At Tax Hack, we live and breathe taxes for real estate professionals, so contact us to set up a tax planning strategy session!