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 MARTERIAL 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 maintaince, 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 REP 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): REPs 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 REP 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.