Real Estate Professional Status

For tax­pay­ers engaged in real estate activ­i­ties, the cov­et­ed “Real Estate Pro­fes­sion­al” (REP) sta­tus can offer sig­nif­i­cant tax advan­tages.

The Inter­nal Rev­enue Ser­vice (IRS) delin­eates spe­cif­ic cri­te­ria for indi­vid­u­als to qual­i­fy as a real estate pro­fes­sion­al, pri­mar­i­ly impact­ing the man­ner in which rental loss­es are treat­ed for tax pur­pos­es. Under­stand­ing the require­ments is a key to open­ing the door of poten­tial tax sav­ings.

This arti­cle delves into the require­ments of REP sta­tus, its ben­e­fits, and com­mon mis­con­cep­tions.

Tax law changes almost dai­ly, so what’s cor­rect on the date of writ­ing this arti­cle, may not be cor­rect at the time you read it. Keep that in mind as you explore the rules to qual­i­fy as a Real Estate Pro­fes­sion­al in the eyes of the IRS.

Tak­ing rental prop­er­ty loss­es against oth­er income.

Gen­er­al­ly, the top­ic of Real Estate pro­fes­sion­al Sta­tus aris­es when a rental prop­er­ty own­er wants to deduct and use rental loss­es, often on paper only, to off­set oth­er income, such as income from a W2 type of employ­ment. Under cer­tain con­di­tions, this can have a mas­sive impact on tax­es owed and is very attrac­tive, albeit only if you qual­i­fy.

Because this is such a com­mon top­ic or moti­va­tion for under­stand­ing the Real Estate Pro­fes­sion­al Sta­tus, I’ll dis­cuss this top­ic first, and if you already know, you can skip to see what the rules are for REP sta­tus.

A lit­tle his­to­ry, pri­or to The Tax Cuts and Jobs Act, being a real estate pro­fes­sion­al meant the tax­pay­er gen­er­al­ly could take unlim­it­ed rental loss­es against their ordi­nary income. This was won­der­ful for those with one spouse as the REP and the oth­er with W2 income.

The change in tax law cre­at­ed new lim­i­ta­tions and con­sid­er­a­tions, albeit REP sta­tus is still a very pow­er­ful tool for those who can take advan­tage of it.

Pas­sive Activ­i­ty Lim­its on ordi­nary income:

Under the cur­rent pas­sive activ­i­ty rules, tax­pay­ers can deduct up to $25,000 in pas­sive loss­es against ordi­nary income (ie W2 wages/income) if your mod­i­fied adjust­ed gross income (MAGI) is $100,000 or less. It does not mat­ter if you’re mar­ried or not, it’s still the same $100,000 ordi­nary income lim­it you’re con­tend­ing with.

Once a tax­pay­er reach­es above $100,000 of MAGI, the pas­sive loss deduc­tion begins to phase out $1 for every $2 of MAGI above $100,000 until $150,000 when the deduc­tion com­plete­ly phas­es out. The lim­it applies to both fil­ing sin­gle or mar­ried fil­ing joint tax­pay­ers.

Also, to take loss­es against your ordi­nary income, the tax­pay­er must be able to demon­strate ACTIVE par­tic­i­pa­tion in the rental activ­i­ty. For­tu­nate­ly, active par­tic­i­pa­tion is eas­i­er to demon­strate than MATERIAL par­tic­i­pa­tion for Real Estate Pro­fes­sion­als as described in detail below.

In order to be an active par­tic­i­pant, gen­er­al­ly, the tax­pay­er must show they are mak­ing mate­r­i­al man­age­ment deci­sions of the rental busi­ness.

For the amounts over and above $25,000, the amount of loss isn’t lost com­plete­ly, the tax­pay­er has the abil­i­ty to car­ry the loss­es for­ward to future years, how­ev­er, obvi­ous­ly that’s not as advan­ta­geous as tak­ing the deduc­tion today for most tax­pay­ers.

That’s why it’s impor­tant to plan ahead for how much you want to deduct in any giv­en year. Rental prop­er­ty own­ers often have flex­i­bil­i­ty in the amount of loss through depre­ci­a­tion, and name­ly through HOW the prop­er­ty is depre­ci­at­ed.

Using the 27.5 years depre­ci­a­tion sched­ule for a res­i­den­tial rental prop­er­ty is allowed, how­ev­er, often a tax­pay­er will want to break out the var­i­ous com­po­nents of a rental prop­er­ty to speed up the depre­ci­a­tion process. There is some sig­nif­i­cant flex­i­bil­i­ty, that many tax­pay­ers can take advan­tage of with prop­er plan­ning.

• Back­ground: Pas­sive Activ­i­ty Loss Rules

Before delv­ing into the Real Estate Pro­fes­sion­al sta­tus, it’s impor­tant to under­stand the con­text. Gen­er­al­ly, the IRS treats rental real estate activ­i­ties as pas­sive, regard­less of the tax­pay­er’s par­tic­i­pa­tion. Pas­sive activ­i­ty loss­es (PALs) are gen­er­al­ly only deductible against pas­sive income, not against active or port­fo­lio income.

This means that loss­es from pas­sive rental real estate activ­i­ties can’t off­set non-pas­sive income like wages, inter­est, or div­i­dends, poten­tial­ly lead­ing to those loss­es being car­ried for­ward indef­i­nite­ly.

As long as the tax­pay­er is an active par­tic­i­pant, and below the income (and pas­sive loss) lim­its described above, it’s gen­er­al­ly the same as hav­ing Real Estate Pro­fes­sion­al sta­tus with­out going to real estate school.

• Real Estate Pro­fes­sion­al Sta­tus: An Excep­tion

The Real Estate Pro­fes­sion­al sta­tus is an excep­tion to the gen­er­al rule men­tioned above. If you qual­i­fy as a REP, your rental real estate activ­i­ties are not auto­mat­i­cal­ly con­sid­ered pas­sive, allow­ing for the pos­si­bil­i­ty to deduct rental real estate loss­es against non-pas­sive income, sub­ject to mate­r­i­al par­tic­i­pa­tion rules.

• Require­ments for REP Sta­tus

To qual­i­fy as a REP, you must meet both of the fol­low­ing cri­te­ria:

More than Half of Per­son­al Ser­vices:

More than half of the per­son­al ser­vices you per­form in all trades or busi­ness­es dur­ing the tax year must be per­formed in real prop­er­ty trades or busi­ness­es in which you mate­ri­al­ly par­tic­i­pate.

750 Hours Require­ment:

You must per­form more than 750 hours of ser­vices dur­ing the tax year in real prop­er­ty trades or busi­ness­es in which you mate­ri­al­ly par­tic­i­pate.

Real prop­er­ty trades or busi­ness­es include any real prop­er­ty devel­op­ment, rede­vel­op­ment, con­struc­tion, recon­struc­tion, acqui­si­tion, con­ver­sion, rental, oper­a­tion, man­age­ment, leas­ing, or bro­ker­age trade or busi­ness.

• Mate­r­i­al Par­tic­i­pa­tion

Even if you qual­i­fy as a REP, each rental activ­i­ty is still con­sid­ered pas­sive unless you mate­ri­al­ly par­tic­i­pate in the activ­i­ty. Mate­r­i­al par­tic­i­pa­tion tests are designed to mea­sure the extent of an indi­vid­u­al’s involve­ment in a par­tic­u­lar activ­i­ty. There are sev­en mate­r­i­al par­tic­i­pa­tion tests, and meet­ing any one of them for a par­tic­u­lar prop­er­ty means you’re con­sid­ered to mate­ri­al­ly par­tic­i­pate in that prop­er­ty.

The most com­mon­ly relied upon tests include:

 Par­tic­i­pat­ing in the RENTAL activ­i­ty for more than 500 hours in the tax year.

 Your par­tic­i­pa­tion in the activ­i­ty con­sti­tutes sub­stan­tial­ly all the par­tic­i­pa­tion for that year.

 You par­tic­i­pate in the activ­i­ty for more than 100 hours in the tax year, and no oth­er indi­vid­ual par­tic­i­pates more than you, and this includes oth­ers who did­n’t own an inter­est in the activ­i­ty for the year (think main­te­nance, clean­ing and oth­er con­trac­tors).

You mate­ri­al­ly par­tic­i­pat­ed in the activ­i­ty (oth­er than by meet­ing this test) for any FIVE (whether or not con­sec­u­tive) of the 10 imme­di­ate­ly pre­ced­ing tax years.

Based on all the facts and cir­cum­stances of the tax­pay­er’s par­tic­i­pa­tion, the par­tic­i­pa­tion in the activ­i­ty was on a reg­u­lar, con­tin­u­ous, and sub­stan­tial basis dur­ing the tax year.

• Group­ing of Rental Activ­i­ties

One strate­gic deci­sion REP-eli­gi­ble tax­pay­ers face is whether to group rental activ­i­ties. The IRS allows tax­pay­ers to treat mul­ti­ple rental activ­i­ties as a sin­gle activ­i­ty for mate­r­i­al par­tic­i­pa­tion pur­pos­es. This can make it eas­i­er to meet the mate­r­i­al par­tic­i­pa­tion stan­dard. How­ev­er, once you elect to group your rental activ­i­ties, you must con­tin­ue to group them in future years unless there’s a sig­nif­i­cant change in your cir­cum­stances.

• Ben­e­fits of REP Sta­tus

Deduc­tion of Rental Loss­es Against Non-Pas­sive Income: This is the pri­ma­ry advan­tage. Sub­ject to pos­si­ble lim­i­ta­tions beyond the scope of this arti­cle, qual­i­fy­ing as a Real Estate Pro­fes­sion­al allows you to deduct loss­es from rental activ­i­ties against non-pas­sive income if you mate­ri­al­ly par­tic­i­pate in the rental activ­i­ties.

Exemp­tion from Net Invest­ment Income Tax (NIIT): Real Estate Pro­fes­sion­als may also be exempt from the 3.8% NIIT on rental income, giv­en that the income is derived from a non-pas­sive activ­i­ty.

• Com­mon Mis­con­cep­tions

Sim­ply Hav­ing a Real Estate License: Just because you have a real estate license doesn’t auto­mat­i­cal­ly qual­i­fy you as a REP. You must meet the spe­cif­ic cri­te­ria men­tioned above.

Assum­ing All Rental Activ­i­ties are Non-Pas­sive: Even if you qual­i­fy as a REP, each rental activ­i­ty must meet the mate­r­i­al par­tic­i­pa­tion tests to be con­sid­ered non-pas­sive.

• Doc­u­men­ta­tion & Proof

Main­tain­ing thor­ough doc­u­men­ta­tion is cru­cial for those claim­ing REP sta­tus, as the IRS fre­quent­ly exam­ines these claims. A con­tem­po­ra­ne­ous log or diary of hours spent on real estate activ­i­ties, detail­ing the date, time, descrip­tion, and dura­tion of the activ­i­ty, is invalu­able.

Achiev­ing Real Estate Pro­fes­sion­al sta­tus offers sub­stan­tive tax ben­e­fits, par­tic­u­lar­ly for those with sig­nif­i­cant rental loss­es. How­ev­er, the IRS cri­te­ria are strict, and the onus is on the tax­pay­er to prove eli­gi­bil­i­ty.

It’s high­ly advis­able for any­one con­sid­er­ing claim­ing Real Estate Pro­fes­sion­al sta­tus to con­sult with a tax pro­fes­sion­al to ensure com­pli­ance with IRS require­ments and to opti­mize the asso­ci­at­ed tax ben­e­fits. If you have more ques­tions, feel free to give me a call to dis­cuss.