Few asset classes offer investors more tax opportunities than real estate. Owning and operating a real estate portfolio unlocks the opportunity for all kinds of tax strategies, minimizing an individual’s tax burden while affording them the opportunity to build significant wealth.
One of the most tax-efficient strategies for real estate investors is to qualify as a real estate professional. This tax designation permits real estate professionals to use losses generated by their real estate portfolio (most often through depreciation) to offset non-passive income, such as that from a W-2 job or ownership of a business.
Given that real estate losses can typically only be used to offset other passive income, real estate professional status is an appealing tax strategy. For high earners, the reduction in federal tax liability can easily add up to tens or hundreds of thousands of dollars in savings each year. With such attractive benefits, it’s natural for those in the real estate community to explore their eligibility for this tax treatment.
Determining eligibility demands both real estate and tax knowledge and can be nuanced. For that reason, taxpayers should consult with a tax advisory firm that is experienced in the real estate industry. Various factors drive the decision, from the taxpayer’s filing status to the nature of their real estate activities. By understanding the basic principles of Real Estate Professional Status, taxpayers can begin to assess whether pursuing this tax strategy may make sense for them.
Real Estate Professional Status, often shortened to REPS, is a tax designation that taxpayers can elect when filing their tax returns.
By electing to be taxed as a real estate professional, taxpayers overcome the presumption that the income from their real estate activities is passive, therefore allowing them to use it to offset their non-passive income, including W-2 income or income from the ownership of a business. Considering the losses that real estate can produce through depreciation, particularly bonus depreciation, taxpayers who qualify for REPS are often able to offset significant amounts of income.
There are no formal qualifications to become a real estate professional. Taxpayers don’t even have to hold a job in a real estate business: they can qualify through their own investment portfolio. However, there are certain qualifying activities, which we’ll explore below, that a taxpayer must complete to be considered a real estate professional in the eyes of the IRS.
At Smith + Howard, we see three main categories of taxpayers who often represent a good match for REPS:
The reality is that every taxpayer’s situation is different. Qualifying as a real estate professional really comes down to satisfying the conditions specified by the IRS.
For a taxpayer to prove that they qualify as a real estate professional, they must be able to prove that they satisfy two key tests:
These tests may sound fairly straightforward, but several intricacies inherent in these rules often cause confusion.
First, only certain activities count toward the 750-hour threshold. Time spent actively managing properties, such as communicating with tenants and working on maintenance or property improvements does count. Other activities, specifically education time spent researching properties or investor hours spent evaluating financial performance, do not count towards the 750-hour threshold.
Some taxpayers aim to satisfy the first test, but neglect the second, spending over 50% of all their working time in a year on their real estate business. If a taxpayer has a full-time job outside of the real estate industry, it is near-impossible to satisfy this test in the eyes of the IRS.
For taxpayers who have a rental real estate portfolio, there are also additional hurdles to overcome to have income (and losses) be characterized as non-passive. While passing the two tests above qualifies a taxpayer as a real estate professional, the taxpayer must also “materially participate” in rental activities to have this income to be recharacterized as non-passive. There are seven tests for material participation. These are defined under Reg 1.469-5T(a) and a taxpayer must satisfy one test to achieve a non-passive characterization.
Another nuance to note is that it is possible to aggregate activities. If a taxpayer works in the real estate industry and operates their own portfolio distinct from this, they may elect for these activities to be grouped together.
Taxpayers may also group multiple properties together using a grouping election to satisfy material participation rules in aggregate across multiple properties, rather than in each individual property. If a taxpayer has suspended passive losses, this election could cause issues, and it is recommended that individuals consult with a taxpayer before making this election. This grouping election falls under Section 1.469-9 and is different from the election used to aggregate hours spent across different activities.
If a taxpayer chooses to pursue real estate professional status, they must commit to collecting a body of proof that justifies this position throughout the year. Real estate professional status is among the most litigated areas of the tax code. The IRS regularly examines and/or audits taxpayers who have elected real estate professional status.
Provided you’re adequately prepared, there’s nothing to worry about. To substantiate real estate professional status, taxpayers should keep detailed time logs, backed with evidence such as receipts, emails, calendar appointments, and more. In the event of an examination or audit, the burden of proof is on the taxpayer, not on the IRS.
Qualifying and substantiating a position as a real estate tax professional is a tax strategy that can result in significant tax benefits. For investors, high-earners, business owners, and those employed in the real estate industry, electing to be taxed as a real estate professional can significantly accelerate wealth accumulation.
However, qualifying for this tax treatment and substantiating your position is not as straightforward as many taxpayers believe. Ensuring that your real estate activities satisfy the criteria, and collecting the body of evidence that proves this, are vital steps in successfully executing this tax strategy and require the guidance of an experienced real estate tax advisor.
At Smith + Howard, our real estate tax team has vast experience across all areas of real estate tax strategy. Our CPAs offer a wide range of tax services tailored to the needs of all real estate players, from large homebuilders to individual investors. With a breadth of knowledge and connections to multiple real estate service providers, our team is committed to helping members of the real estate industry build and execute efficient tax strategies.
To learn more about how Smith + Howard can support your real estate tax planning needs, contact an advisor today.
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