What it Takes to Get Real Estate Professional Status and Why it Matters for Passive Investing
There are dozens of ways to have a career in real estate, from selling luxury homes to fixing and flipping distressed properties and everywhere in between. While these are professions in the real estate industry, achieving real estate professional tax status is a separate topic, not to be confused with the former. We bring up this point because this is a topic that many real estate investors tend to hear about at some point in their journey but are not always clear exactly what it means.
Gaining real estate professional status is a great way to reap additional tax savings benefits if you are investing in real estate either actively or passively. The reasoning behind this is that once you are able to claim this status, you can actually offset your active income (from let’s say your full time job) with your passive income losses (like those you receive from a multifamily syndication). This can be a huge advantage when tax time rolls around.
For someone to officially achieve real estate professional tax status, they must meet three specific criteria set forth by the IRS, which we will dive into below.
What is IRS Real Estate Professional Status?
Real estate professional status (REPS) is a tax tool created by the IRS for real estate investors that allows qualifying tax payers to dramatically limit their tax exposure. REPS is designed to free up passive real estate losses that can be used to your advantage when filing taxes. Based on a few qualifications, real estate professionals can potentially lower their tax bill from 35 to 15 percent or less by writing off passive losses, which would otherwise go against the internal revenue code.
How To Achieve Real Estate Professional Tax Status
REPS is achieved by passing a three-pronged test. The three qualifications are as follows:
You spend 750 hours per year on real estate related activities.
AND you spend 50% of your time in real estate.
You pass one of the seven ‘material participation’ tests outlined by the IRS.
Let’s break these requirements down a bit more.
The first two qualifications (750 hours and 50% of your time) must be simultaneously met each year. For example, if you document 750 working hours in real estate but maintain a 40-hour, non-real estate job, the IRS will assume that it is impossible for you to meet the 50% of your time requirement. The time thresholds can be met through a variety of activities. Whether you manage short-term rentals like Airbnbs, long-term rental properties such as multifamily apartment buildings, you flip houses, wholesale properties, or a combination of everything, it all counts towards those hours.
There are creative ways to achieve real estate professional status without quitting your full-time job including the option of going part-time at your W-2 job or including your spouse if you file taxes jointly. If your spouse either doesn’t work a W-2 job or works part-time and is willing to put in the necessary hours, you have the opportunity to meet the 50% requirement together while maintaining your salaried income.
The third qualification for real estate professional status is based on material participation. This means that you are actively involved in the properties that you own. The internal revenue code states that real estate investors must meet at least one of the seven tests to meet the material participation requirement.
According to IRS.gov, the seven material participation tests are as follows. You must pass at least ONE, in combination with the aforementioned requirements, to be considered a real estate professional.
You participated in the activity for more than 500 hours.
Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Most investors opt for the first test of 500 hours. The caveat is that those 500 hours must be spent on properties that you personally own and are actively involved with, however the time can also be combined with material participation by your spouse. This means that being a limited partner in a multifamily real estate syndication or contributing through hard money lending does not count, as you are not materially participating.
It is important to note that these qualifications must be met each year. While you may qualify for REPS one year, it doesn’t necessarily mean that you will qualify the following year. It is critical that you meticulously document your time and real estate related activities throughout the year.
The IRS requires that however you log your participation and hours be kept consistent. So, whether you use an Excel spreadsheet, a notebook, Google calendar, or a time documenting app, the most important thing is consistency.
When tracking your time, make note of the date, the related activity, the duration of time spent, and the property associated with the activity.
For example:
April 20, 2022
Conducted a walkthrough for potential investment.
123 Apple Street.
1.5 hours
In the event of an audit, you will want to have substantial activities documented and readily available.
Benefits of Real Estate Professional Status As a Passive Investor
We know that real estate is a tax shelter, which is one of the main reasons so many of us choose to invest. As we mentioned before, real estate professional status is a huge opportunity to offset your taxable income with passive losses.
Without REPS, you are limited in what you can write off because you can only offset passive income with passive losses. When you qualify for REPS, you are able to use passive losses from depreciation against both active AND passive income, resulting in less IRS taxable income. Using REPS and the tax benefits associated with it is how many investors pay zero dollars in taxes each year. Learn more about how to minimize your tax exposure in this blog.
Conclusion
Real estate professional status is a code set in place by the IRS to benefit high-income investors when tax season rolls around. While REPS may not be for everyone, as it requires a great deal of documentation and specific requirements, it is a commonly used tool for investors looking to minimize their tax burden. This blog is a high level explanation of what REPS is, how to achieve it, and how it can benefit you, however it is important to thoroughly read the IRS REPS guidelines and consult your personal tax professional before opting for this route.
Note: This article is not meant to serve as tax advice and we are not tax professionals. Calculating how REP status might benefit you is complex to navigate. We always suggest you consult with your CPA on your specific tax situation and what is possible for your current tax obligations.
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