Even if you see yourself as a real estate professional, the IRS may disagree to that classification. The requirements to qualify as a real estate professional for tax purposes can be nuanced. However, meeting their criteria can allow you to realize helpful losses on your tax return.
In this post, we'll explore what it takes to achieve real estate professional (REP) status, the lucrative benefits you gain if you qualify.
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What is a Real Estate Professional?
Rental real estate activities are typically considered passive by the IRS, meaning losses generated from them can only be used to offset other passive income. Any remaining losses are suspended and carried forward, potentially remaining unused for several years.
However, there are two exceptions that allow some rental real estate losses to offset non-passive income:
Taxpayers with an adjusted gross income under $150,000 can deduct up to $25,000 in rental real estate losses against active income.
Individuals who qualify as a "Real Estate Professional" can treat rental real estate activities as non-passive, allowing losses to offset active income.
If you qualify for REP status, losses from rental real estate may not be restricted to only offsetting passive income. This means there's no restriction on the amount of losses that could potentially offset active income.
The IRS defines a REP as someone who:
As long as you meet both requirements, you qualify as a real estate professional in the eyes of the IRS:
Spends at least 750 hours per year working in a real estate trade or business. This includes time spent on rentals, flips, brokers fees, commissions, and much more.
Earns at least 50% of their annual income from real estate activities. This includes income from wages, real estate commissions, rents, capital gains on sales, and more.
While 750 hours over the year amounts to less than a standard 40-hour full-time job per week, managing rentals for at least 25 hours weekly easily satisfies this requirement.
However, meeting the hour requirement alone is not sufficient - your real property work must also surpass the time you spend in other occupations. For example, if you have another job where you work 30 hours per week, you would need to spend more than 30 hours per week on qualifying real estate activities.
This rule makes it highly improbable for someone with a full-time job in an unrelated field to qualify for Real Estate Professional (REP) status. The IRS is unlikely to accept that you can transition from working 40 hours as an employee and then devoting over 40 hours per week exclusively to real estate.
The Big Tax Benefit of Being a Real Estate Professional
The main benefit of qualifying as a real estate professional in the eyes of the IRS is the ability to deduct rental property losses against your ordinary earned income, like W-2 wages or self-employment income.
Consider a marketing executive who owns five rental property as a side investment. Despite actively managing the property, they don't meet the criteria to qualify as a Real Estate Professional. As a result, their rental property generates passive losses that accumulate over time. Since they can't offset these losses against their ordinary income from their marketing job, the passive losses continue to accrue without being utilized.
Unused passive losses can accumulate over time and are typically only realized when a property is sold, potentially offsetting any gains from its appreciation. These unused losses can grow significantly over many years, reaching tens or even hundreds of thousands of dollars. However, many real estate investors opt to retain their properties, relying on the income during retirement, and eventually passing them to their beneficiaries.
Now, let's revisit the marketing executive scenario: Suppose the executive's spouse obtains a real estate license, dedicating time and earning primarily from real estate activities. In this situation, the couple can promptly apply their previously unused passive losses to offset income from the W-2 wage. Moving forward, they'll have the ability to utilize these losses to offset income in the year they're realized.
Numerous real estate investors opt to shift from their W-2 employment to Real Estate Professional status once their investment earnings can sustain their lifestyle. With effective tax and financial planning, this transition can lead to early retirement in a significantly lower tax bracket or enable pursuing hobbies without the constraints of a traditional 9-5 job.
Who Should Become a Real Estate Professional?
If you have investment properties that generate a loss and spend significant time each year managing those properties or working as a real estate field, achieving REP status can provide huge tax rewards.
It offers the biggest benefits to landlords with multiple rental properties producing losses. By converting these passive losses into deductible business losses, you can write off up to $100,000+ against your W-2 income.
Agents who earn all or most of their income from real estate commissions can also benefit. You may be able to deduct normally disallowed business expenses like vehicle mileage, home office spaces, and more.
Investors who flip houses may also benefit, but the rules are complex for short-term holdings. You may need to aggregate flips with other activities to hit the 750 hours and 50% income requirements.
Note - being recognized as a real estate professional offers advantages primarily when one faces losses on an investment property, as it enables the utilization of these losses to offset ordinary income. Without experiencing losses, the status holds no significant benefit, as its main advantage lies in mitigating financial liabilities through loss deductions.
If you're currently realizing a profit, you can explore strategies like bonus depreciation or cost segregation to take a higher amount of depreciation and potentially turn your profit into a paper loss for tax purposes. These tactics offer you avenues for optimizing your losses and maximizing the potential advantages of real estate professional status.
Maximizing the 750 Hours Real Estate Professional Requirement
The 750 hour requirement is what stops most investors from qualifying as an REP. So you'll need to carefully track and document all time spent on real estate activities.
Mundane property management tasks like minor repairs, bookkeeping, and rent collection all count. Travel time and phone calls count too.
Leverage tools like calendars, activity logs, receipts, and property management software to document your time. Over-document everything, because the IRS may request proof.
Oh, and by the way United Tax provides a free spreadsheet to track your hours and expenses.
If you spend 25+ hours per week on rental activities, meeting 750 hours is no problem. If not, find ways to increase your time like self-managing properties, doing maintenance yourself, or taking over accounting.
The key is demonstrating real, substantive participation in real estate activities. Avoid fluff hours that don't contribute value.
5 Frequently Asked Questions on Real Estate Professional Status
1. Do I need a real estate license to be considered a real estate professional?
No. You do not need an agent's license to achieve REP status. The IRS only cares about your time and income thresholds. Many rental property investors become REPs without a real estate license.
2. How do I determine if 50%+ of my income is from real estate activities?
Add up all your income reported on Schedules C, E, F, Form 4797, and Schedule K-1. Also include wages, commissions, and ordinary gains from real estate activities. Divide your total real estate income by your adjusted gross income.
Capital gains from selling properties do not count as real estate income for this test unless you worked at least 750 hours on that property in the year sold.
3. Can my spouse's REP status and RE losses be use to offset my W2 income?
Yes, many married couples utilize the REP status strategically to offset a significant portion of ordinary wages. If your spouse qualifies as a Real Estate Professional and you file a joint return, you can use all the real estate losses to offset all ordinary income on a joint return.
4. What records should I keep to prove I met the 750 hours test?
Track everything related to your real estate activities - time logs, calendars, receipts, invoices, property management reports, repair orders, etc. Document phone calls, driving time, and research. Leave an obvious paper trail showing your participation.
5. Can I become a REP if I also have a full-time W-2 job?
To meet IRS criteria for Real Estate Professional status, your primary work and more than 50% of your time must be in a real property trade or business. If you work for a company where you don't own at least 5%, even if it operates in real estate, you would be disqualified.
Consider this: A real estate developer who's a partner in the company they receive a paycheck from can still qualify for REP status because real estate development is recognized as a real trade or business. However, their eligibility is based on owning more than 5% of the business.
However, their full-time salaried assistant who receives a W-2 paycheck would not qualify, even though their job duties involve real estate work on a full-time basis. This is because the assistant is considered an employee rather than a business owner. This distinction disqualifies most W2 employees from qualifying as a real estate professional.
The Bottom Line To Real Estate Professional Tax Benefits
Becoming a Real Estate Professional opens up substantial tax advantages for active real estate investors, flippers, landlords, and agents. But you must be ready to thoroughly track your time and income to satisfy the IRS requirements.
Before attempting to qualify, understand the Real Estate Professional criteria in depth. Or, partner with an experienced tax professional who can guide you through the process. We may be a bit biased, but we think we're a great choice.
As we've covered, meeting these guidelines allows your rental property and real estate losses to offset other income. This can add up to major tax savings. However, you need to meticulously log your hours and participation.
If you dedicate over 50% of your work hours to real property trades, spend over 750 hours annually, and have the records to prove it, Real Estate Professional status provides phenomenal benefits. To learn more or get help qualifying, reach out to our expert team here at United Tax. We specialize in assisting real estate investors and other clients realize all available tax rewards.
