Real estate investors enjoy many tax benefits when building a portfolio of rental properties. However, high earning real estate investors may find it more difficult to utilize their rental losses. Therefore, it is important to understand Real Estate Professional Status.
“Disclaimer: This is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Consult with your own attorney, CPA, and/or other advisors regarding your specific situation.”
Scenario - The Passive Loss Problem
Sarah is a working professional married to a stay-at-home dad, making $400,000 annually. According to the IRS, Sarah is a “high earner” and will likely pay taxes on a large percentage of her income every year once you add up federal income taxes, state & local income taxes, property taxes, and sales tax.
Since Sarah wants to make a dent in the percentage of her earnings that are lost to taxes, she decides to start investing in real estate. She understands that if she is careful in her books and record keeping she can take advantage of all ordinary and necessary expenses related to a rental portfolio, and utilize depreciation on her properties to generate a loss even if the properties have positive cash flow.
First, she goes to work on her real estate portfolio, with the goal of buying five rental properties that she plans to hold for a long time. After running the numbers on hundreds of properties, making many offers, educating herself on real estate investing using professionals and resources like Bigger Pockets, and being frugal so there is cash available to use as down payments and make repairs, she acquires the five properties.
Sarah is excited for tax time because she knows there are great tax benefits to owning real estate investments. Unfortunately, Sarah is shocked at her tax bill, because there were not any tax savings for this year from her rental losses.
Per IRC Section 469, rental real estate is considered a passive activity by default. This characterization means that losses from rental real estate can only be used to offset other passive activities that have income. For households with a lower income, the passive activity loss rules are not quite as strict. For Sarah’s family, since she is a high earner, all of the passive losses from her real estate portfolio will have to be carried forward until her real estate generates income.
Under $150,000 Rule
If Sarah’s income was under $100,000, she would be allowed a special allowance of $25,000 for passive rental losses (the amount of loss allowed begins being phased out when income exceeds $100,000 and is completely phased out when income exceeds $150,000). However, Sarah makes $400,000 from her job, so all of her losses were not available to be used this year and will be carried forward until she has more passive real estate income.
The Solution - Real Estate Professional Status
Real Estate Professional status is simply a designation that you elect on your tax return, if you qualify. By making this election, individuals can use the losses from their real estate activities to offset any income (even non-passive income like W-2 earnings or business ownership).
This can have large implications for wealth building since the tax savings can be utilized to invest in more passive income streams, accelerating an individual’s financial goals.
In Sarah’s situation, she would not be able to qualify as a real estate professional since she works very hard at her W-2 job to earn such a high salary. However, if her husband is willing to take on the management activities of their portfolio, they could claim the losses generated by the new rental properties to offset their family’s high earnings from a W-2 job. Depending on their financial goals, there is the potential to unlock serious tax savings!
So what are the requirements to be a Real Estate Professional for tax purposes?
Requirement #1 - 750 Hour Test
The person claiming real estate professional status must spend at least 750 hours in qualified real estate professional activities as defined by the IRS (from January 1 - December 31). The time log must be kept contemporaneously throughout the year, which means you can not create it retroactively should your tax return be under examination. These activities include real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage. You must also own at least a 5% equity stake in the real property trade or business.
Requirement #2 - Proportion of Time
The person claiming real estate professional status must spend more time in real estate than in their other jobs combined. In our example above, since Sarah was married to a stay-at-home dad who was not working to earn income from any other sources, he only needed to show being involved in real estate for 750 hours to qualify. On a joint tax return, only one spouse needs to qualify.
Requirement #3 - One Taxpayer
The time requirements must be met by one taxpayer and cannot be a combined time of two individuals.
Material Participation
In addition to the three requirements, a real estate professional needs to be able to show that they “materially participated” in the rental properties that they own. The IRS has seven tests that may be used to determine whether the taxpayer meets the requirements, and you only need to meet one of the seven tests to qualify.
Did you work more than 500 hours in the rental activity during the year?
Did you perform substantially all of the work in this activity, as compared to everyone else who worked in this activity during the year (including non-owners)?
Did you spend at least 100 hours in the rental activity and spend more time than any other individual?
If you spent at least 100 hours during the year on each of your rental activities, but you can’t pass any of the other material participation tests listed herein, then you can still qualify for material participation if your total hours combined for all of your rentals exceeds 500 for the year.
Did you meet the material participation test at least five out of the last ten years?
If this is a personal service activity, did you meet the material participation requirement for any of the three prior years?
Under all facts and circumstances, did you participate in the activity on a regular, continuous, and substantial basis during the year?
*Spouse’s Time: For purposes of the seven material participation tests above, your time spent in an activity includes your spouse’s participation time as well. This applies even if you do not file a joint return with your spouse and/or even if your spouse doesn’t own an interest in the activity.
Section 469 Grouping Election
The real estate professional status assumes that you materially participate in each rental property. This can create a significant issue for investors with large or passive portfolios since they will most likely not be able to meet the criteria for each property.
The Section 469 grouping election is a statement that is required to be attached to your tax return. This will allow the taxpayer to group all of their rental properties into one economic unit, allowing them to meet the material participation requirements using their entire rental portfolio, rather than each individual property.
It is important to work with your tax advisor and think long-term when making the Section 469 grouping election since there are some concessions that are made upon the sale of your properties in future years.
Does it ever make sense to avoid Real Estate Professional status?
There are situations where the long-term consequences of claiming real estate professional status are not worth the short-term benefits. Sometimes real estate investors become obsessed with reducing their tax bill this year, without considering the tax situation they are creating down the road. Make sure to work with a real estate CPA who can explain your options for action, and the net effect of those choices both short and long term.
Real Estate Professional status is only beneficial to those with rental losses who do not plan to sell those rental properties in the near future. If you work as an agent, wholesaler, property manager, lender, or contractor and you do not own rental properties, or your rental properties are profitable with low depreciation, real estate professional status will not be helpful.
Conclusion
The key to successfully claiming real estate professional status is documentation, documentation, documentation! Not claiming the real estate professional status correctly, or not including the right elections with your tax return, are two of the most costly mistakes made by real estate investors. Make sure to work with a real estate CPA on a consistent basis to be certain you have the right strategy to achieve your financial goals.
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