The importance of determining whether a taxpayer involved in real estate activities is a real estate professional must be clarified. This blog post will help you understand the basic rules for real estate professionals.
What is a Real Estate Professional?
It’s easy to get confused about what a real estate professional is. After all, it’s a very general term. At first glance, you might think it would apply to brokers, investors, property managers, etc. But from a tax perspective, the term ‘real estate professional’ has a very specific definition.
A real estate professional is a designation you elect on your tax return. By electing to be taxed as a real estate professional, individuals can use the losses from their real estate activities to offset any income, including non-passive income earned through a W-2 job or business ownership.
However, only some real estate investors qualify as real estate professionals. There are many tax rules for real estate professional tax status, and to substantiate this position, individuals have to meet a series of specific criteria.
How Do You Qualify As A Real Estate Professional?
You don’t need a particular certification or to be an agent or realtor to qualify as a real estate professional. To qualify as a real estate professional, a taxpayer must satisfy the following tests:
Test 1: Greater Than 50% of Services in Real Estate
The first burden you must meet for this classification is to spend more than 50% of your time working in real estate trades or businesses wherein you are a material participant.
The key to meeting this burden is that your main source of income needs to be derived from real estate activities. Your total time spent on personal services includes your time as an employee.
However, you can only have time as an employee on real estate activities if you own at least 5% of the company. Also, if you file a joint return, don’t count your spouse’s services to see if you meet the other standards.
Test 2: Establishing A Material Participation
Once you’ve established that you’re a real estate professional tax status, the last hurdle is to verify that you materially participate in managing your rental properties. To develop material participation, you must meet the criteria of material participation. Involvement in controlling the activity doesn’t count in determining whether you materially participated under this test if one or more of the following applies:
Someone other than yourself received compensation for managing the activity or
Any individual spent more hours during the tax year managing the activity than you did, regardless of whether the individual was compensated for the management services.
Additionally, you are a real estate salesperson. In that case, you cannot group your hours worked as a salesperson with your rental real estate activities to determine material participation.
Test 3: Completing the 750-hour Requirement
The second qualification requires real estate professional tax status requirements to spend more than 750 hours per year performing services related to real estate trades or businesses. The 750-hour tests must be met by one spouse alone.
However, all real property trade or business activity is included under the 750-hour test, regardless of whether an election has been made to aggregate the properties into one real property trade or business.
Example
In 2022, Mr John worked as a part-time accountant. He was also a real estate developer and owned three rental properties. The following applies to his business activities in 2022:
- Spent 200 hours during the year working as an employee for a local accountant
- Spent 500 hours engaging in real estate development activities for which he materially participated
- Spent 300 hours during the year providing manager services for each of his three rental properties for which he materially participated
Conclusion: Mr. John is a real estate professional. This is because more than half (80%) of all his services performed during the year were in real estate property trades or businesses wherein he materially participated, plus he spent more than 750 hours engaged in these services.
Since he is a real estate professional and materially participated in the three rental properties, income and loss from these properties will be treated as nonpassive.
How To Document Real Estate Professional Status To The IRS
The IRS will require supporting documentation before receiving real estate professional tax status. This can be done using any method: Excel workbooks, Google Sheets, time-tracking websites, etc.
The real estate professional tax status irs has no requirements for submitting these hours, though they will require you to be consistent during the tax year. Investors should maintain their systems throughout the year rather than combine them simultaneously. There are a few different things the IRS will look for when reviewing your hours:
- The time and date
- The activities performed
- The duration of your work time
- The address of your work or related property
Will Passive Investments Help You Qualify?
You need more than passive investments to qualify as a real estate professional tax status. As mentioned above, the IRS has strict criteria for determining who qualifies. Real estate professionals status need to prove a minimum number of hours worked, among other things, making it difficult for passive income investors to meet the requirements.
Passive income investors may spend a few hours a week or month checking in with their property managers, but more involvement is needed to complete the IRS standards. Consider documenting your participation if your “passive investments” require substantial time and work.
This information can help you determine if you qualify and potentially even realize that your role is not so passive.
How To Document “Unprovable Time”
It may seem impossible to count your working hours over a year; after all, things can come up unexpectedly. These situations, where there is no supporting evidence, are referred to as “unprovable time,” and there are guidelines you should follow before documenting them.
The IRS will generally apply a reasonable test to these hours. For example, spending 6 hours repairing a water leak on one of your rental properties sounds good. However, documenting these repairs for 48 hours may raise some red flags with the IRS.
Tax rules for real estate professionals
Once an individual has qualified as a real estate professional, they should be following the tax obligations given below:
Deductibility of losses on the disposition of real estate
The determination of whether a taxpayer is a real estate professional logbook, can affect the classification of a tax loss on the sale or disposition of real property. This is because a loss generated on property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business is deductible as a typical loss rather than a capital loss.
Additionally, the us real estate professional tax status spouse can influence the tax treatment, potentially affecting their joint tax implications.
Net investment income tax
In the case of a U.S. citizen or resident, a net investment income tax of 3.8% applies to the lesser of the individual’s net investment income for the tax year or the excess (if any) of the individual’s modified adjusted gross income for the tax year, over the threshold amount.
A taxpayer is not subject to the net investment income tax if the taxpayer’s MAGI is under the threshold amount.
Passive Loss Rules
Per IRC Section 469, rental real estate is considered a ‘per se’ passive activity. This characterization means that by default, losses from rental real estate (typically achieved by depreciation) can only be used to offset other passive income, such as rental income.
For investors, this means that losses from a rental real estate portfolio cannot be used to offset non-passive income, such as income from a W-2 job or business ownership. This can limit the potential tax benefits of investing in real estate.
Real Estate Professional Tax Benefits
Here are some key points regarding tax benefits for real estate professionals:
- Active participation in rental activities allows real estate professionals to deduct rental losses against their non-passive income, up to $25,000, subject to income limitations.
- Depreciation deductions, real estate professional tax deductions, enable to deduct the cost of their rental properties over their useful life, reducing taxable income.
- The professionals may be eligible for a home office deduction if they use a portion of their home exclusively for business.
- Self-employment tax deductions enable real estate professionals to deduct some of their self-employment taxes as a business expense.
- Real estate professionals who meet certain criteria may be exempt from the passive activity loss rules, allowing them to deduct losses from their rental properties against other income without limitation.