Table of Contents
- 1 Quick History on Passive Losses
- 2 Real estate professional tax loophole
- 3 What is ordinary income?
- 4 Part 1: What activities qualify for real estate professional status
- 5 Part 2: Material Participation
- 6 Is a landlord a real estate professional
- 7 Frequently Asked Questions About The Real Estate Professional Tax Loophole
- 8 Real Estate Professional Status - Conclusion
Real estate, especially Multifamily properties, have many benefits, such as creating an income stream that grows yearly while acting as a strong hedge against inflation. But another big reason why the real estate industry is so powerful is that it has many fantastic tax benefits that allow real estate investors to create paper losses through what the IRS calls Depreciation.
Depreciation is not an actual operating loss; it’s a paper loss that you can apply against the cash flow of a rental property. The ability to depreciate and create these losses on paper to lower the taxable amount within the property is a clear road. Still, when you’re paying yourself personally, that’s a different set of tax rules.
The general rule from the IRS is that all rental real estate activity is passive, meaning that passive losses from rentals can only be offset by other passive income or gain. So as a real estate investor, you’d ideally want your passive losses to be re-characterized as non-passive losses. Non-passive losses can offset your other personal income, like your W2 income. This is where qualifying for real estate professional status comes into play.
In this guide, we’ll talk about the most common questions people have, like “do I qualify for real estate professional status,” “Is a landlord a real estate professional,” what it is, and what the tax benefits are by qualifying for it?
Quick History on Passive Losses
IRC Section 469 was a Tax Reform Act introduced in 1986 to eliminate the tax shelter that high-income-earning individuals could take advantage of. These advantages were that you could offset business and rental losses against high-earning W2 income.
So basically, what that meant before 1986 was the following:
For Example, You could be a doctor who earned $ 1 million in W2 income on the year and simply buy a few apartment buildings, accelerate your paper loss through accelerated depreciation, and offset all of your W2 income.
Real estate professional tax loophole
As mentioned at the beginning of this guide, as a real estate investor, you’d want your passive losses to be re-characterized as non-passive losses. Non-passive losses can offset your other personal income, like your W2 income.
To re-characterize rental losses as non-passive losses, the IRS says that you must qualify for at least 1 of the three exceptions that are listed below:
- On the entire disposition of an asset in a fully taxable transaction, both the current and suspended losses can be used to offset wages, portfolio, and other non-passive income (IRC Sec. 469(g)).
- Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income is less than $100,000 (IRC Section 469(i)(2)).
To qualify for this offset, the taxpayer must actively participate, own at least 10% and not be a limited partner. The $25,000 exception is phased out at the rate of $0.50 for every $1 of modified adjusted gross income over $100,000. Therefore, when the modified adjusted gross income exceeds $150,000, the $25,000 offset is not allowed.
- Qualify as a real estate professional under IRC Section 469(c)(7).
What is ordinary income?
Ordinary income is any income earned by an organization that is taxable at ordinary rates, gross rental income would be an example of this.
Part 1: What activities qualify for real estate professional status
Qualifying for real estate professional status does not allow you to deduct your passive loss automatically; you have to participate in your rental real estate activities materially. We’ll go more in-depth on this in the next section.
But to qualify, you must first meet the following;
- You must work at least 750 hours in a real estate trade or business in the calendar year
- More than 50% of the personal services you perform in all businesses during the year MUST be performed in a real estate business you materially participate in.
Joint qualifying with your spouse as a real estate professional
It would be unlikely that if you worked a full-time job as a dentist, for example, you would qualify on your own, but that doesn’t stop your spouse from qualifying and sharing the benefits with you. But you cannot jointly qualify with your spouse based on combining your required material participation hours on the year. Instead, one spouse has to be eligible on their own to achieve the status.
For Example, There was a case of a doctor making $3M a year in active W2 income and had purchased enough commercial real estate and accelerated the depreciation on these assets. He generated enough depreciation or paper loss on this that he was able to offset his entire $3M income on the year.
The IRS had audited him and lost, as his wife, a stay-at-home mom, qualified for real estate professional status as she managed the properties.
Part 2: Material Participation
To pass the material participation requirements, you can only count the personal hours you materially participated in in your real estate business.
The IRS offers seven tests to demonstrate material participation. You must meet at least one of the following and own at least a 5% stake in the asset.
- The individual participates in the activity for more than 500 hours during the year.
- The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.
- The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.
- The activity is a significant participation activity for the taxable year, and the individual’s aggregate participation in all significant activities during that year exceeds 500 hours.
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such a year.
Hours that DON’T count are “Investor Hours.” “Investor Hours” include the following:
- Reviewing financial statements
- Preparing investor reports
- Managing finances
- Researching new properties
Note: If you’re a Limited partner/passive investor in a real estate syndication, you can only establish material participation by meeting #1, #5, or #6 of the test above.
For Example, John works 1000 hours a year as a bike repairman and manages his rental portfolio for about 1001 hours a year. In this scenario, more than 50% of John’s personal working hours went into his real estate business which he also manages, qualifying him for real estate professional status.
Is a landlord a real estate professional
For landlords, material participation is looked at on a per-property level, as landlords typically own more than one property. Meaning you have to prove material participation on each of your rental properties unless you group them together (which is a whole other conversation)
Also, suppose you’re a landlord that uses a 3rd party property management company to run your rental property. In that case, it’ll be a bit tougher proving material participation as, technically, you’re not running the day-to-day operations.
Frequently Asked Questions About The Real Estate Professional Tax Loophole
No, a realtor, who is an individual who acts as an agent to buy and sell real estate for a client, is not to be mistaken for the tax classification “real estate professional.” Being a realtor does not automatically give you real estate professional status; an individual must satisfy specific qualifications to get this tax status.
You would have to prove that you work a minimum of 750 hours in a real estate business and that 50% of your business activity is taken place in this real estate business that you can prove you materially participate in.
The main tax benefit of getting real estate professional status is that you would be eligible to take your passive “paper losses” and re-categorize them to be used to shelter against your earned income from your job.
Real Estate Professional Status - Conclusion
In the most high-level explanation, you have to prove you’re actively managing your rental real estate. The tax benefits can be very lucrative if you qualify. You can significantly lower your tax burden by sharing your converted passive losses into non-passive losses against your active W2 income. As a result, you can keep more money in your pocket, and hopefully, you’ll use that money to re-invest in more real estate to compound those tax savings!
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