Real estate investing can be a powerful tool when planning for early retirement. For one, real estate investments generally require very little involvement, and can create passive income.
Also, when you invest in real estate, you benefit from significant tax deductions, including repairs, maintenance, interest, and depreciation.
One downside is that, when it comes to real estate investments, you are usually limited in how much you can deduct against your other income.
But what if we tell you there is a way to offset this rule by achieving a Real Estate Professional status?
A Real Estate Professional can use losses from real estate investments to offset other ordinary income. Read on to learn more.
This article was submitted by Jorge Sanchez, M.D.
Real Estate Professional vs. Real Estate Investor
Not everyone will qualify for Real Estate Professional Status (REPS). In fact, most real estate investors do not qualify.
Real Estate Professional
A Real Estate Professional provides more than half of their services in real estate. So if you spend 75% of your working time providing physician services and 25% of your time providing real estate services, you would not qualify. People who qualify are usually real estate agents, brokers, or property managers – but that doesn’t mean that other people can’t qualify.
A semi-retired physician who works part-time may be able to put in enough time as a Real Estate Professional to qualify for the designation. More commonly, a non-physician spouse can qualify for REPS, providing the same benefit when the couple is using married filing jointly tax status.
Real Estate Investor
A real estate investor, as defined by the IRS, invests in real estate to generate passive income without an active, time-consuming investment in the properties. A real estate investor has less substantial involvement in the real estate sector than someone deemed a Real Estate Professional.
A real estate investor is less involved in active trade and more focused on maximizing investment returns.
If you qualify as a Real Estate Professional, you can take any losses (such as annual depreciation) on your rental properties and offset your ordinary income.
A real estate investor, on the other hand, is limited to a maximum of $25,000 of deductible losses against ordinary income each year, and this figure starts to phase out once your MAGI (Adjusted Gross Income (AGI) with several additions such as non-taxable Social Security and tax-exempt interest) reaches $100,000. Once your income reaches $150,000, a real estate investor cannot deduct any rental losses against ordinary income.
Note that the phase-out range is the same for single, married filing jointly, and head of household taxpayers. Taxpayers filing with Married Filing Separately status are limited to losses of $12,500 each year, and the phase-out starts at MAGI of $50.000.
Qualifications for Being Considered a Real Estate Professional
Most people get into real estate as an investment or side hustle because of how little time is involved in owning most real estate. As noted above, the IRS has strict criteria for qualifying as a Real Estate Professional as defined in IRC § 469. To qualify, more than half the services you provide must be in the real estate field.
You must also provide at least 750 hours of material participation during the tax year as a Real Estate Professional. The 750 hours must be carefully logged each year if you want your Real Estate Professional designation to hold up in the event of an audit.
Real Estate Professional hours can include any hours you spend on the operation, management, and tasks related to your real estate business. Note that the IRS has specifically excluded hours spent on research of possible investments. So your time spent online looking at properties (or even touring potential properties) does not count towards the 750-hour requirement.
To prove your hours, you’ll need to keep a log of the time spent throughout the year and the activity that was completed during each hour.
Along with the rules to be considered a Real Estate Professional, you will need to pass a material test for your investments. Note that you can group your investments together to achieve thresholds. There are several IRS rules for material participation (note that tests 6 and 7 do not apply to real estate investments):
- Test 1: Participation of at least 500 hours during the year on your real estate investments. (Note that you would still need an additional 250 hours of real estate professional services to meet the 750 hours requirement). Material participation includes the following activities:
- Attending meetings
- Handling administrative tasks
- Making management decisions
- Test 2: Your participation is regular, continuous, and substantial. You would not qualify based on overseeing a one-time large project on your property if you do not normally participate.
- Test 3: You must participate at least 100 hours in this activity, and you must participate more than any other individual in your real estate investment. So if you employ a property manager to handle the day-to-day operations, you would not meet this qualification.
- Test 4: You must be able to prove that you completed the 500 hours required and that you spent at least 100 hours on each investment.
- Test 5: You must have participated materially in at least five out of the prior ten years. Note that these years do not have to be subsequent.
- Test 6: If you participate in a personal service activity (such as medicine or consulting), you qualify if you materially participated in a personal service activity for three out of the previous five years. Note that this test qualifies you for materially participation in the personal service activity, not your real estate activity.
- Test 7: If none of the above tests apply, you can materially participate in an activity by showing regular, continuous, and substantial involvement in that activity as long as the involvement totals at least 100 hours during the year.
Your designation as a Real Estate Professional may change each year based on your participation in your real estate investments and other activities during the year.
As a REP, you may create a net operating loss (NOL), if your real estate losses are more than the rest of your income for the year. For example, if you have a $500,000 rental loss in a year, but only earn $250,000 as a physician, you would have an NOL of $250,000. This $250,000 will be carried forward to the next year and can offset your ordinary income even if you don’t qualify as a REP in that year.
Tax Benefits of Being a Real Estate Professional
The tax benefit of being a Real Estate Professional as opposed to a real estate investor is the ability to offset your ordinary income. As noted before, at most, a Real Estate Professional can only write off up to $25,000 against their ordinary income and most physicians wouldn’t qualify to offset any of their ordinary income with rental losses.
Along with the ability to deduct rental losses against ordinary income, Real Estate Professionals are also exempt from paying the 3.8% net investment tax on any real estate profits from activities in which they actively participated.
Consider a married couple where the husband qualifies as a Real Estate Professional and the wife is a working physician making $250,000. The husband performs more than 750 hours of Real Estate Professional services each year, and they jointly own 3 rental properties that, while profitable for the couple, have a combined tax loss of $40,000 thanks to the magic of depreciation. Before considering the rental loss, this couple would be in the 24% federal tax bracket.
Since the husband is a Real Estate Professional, the couple can claim the $40,000 of rental loss against their ordinary income. While in the 24% tax bracket, this will save the couple $9,600 in federal taxes ($40,000 * 24%).
If couple also made improvements on their property or purchased new furnishings that fall into the 5-, 7-, or 15-year depreciation categories, they could take bonus depreciation on the new assets. For 2023, bonus depreciation is 80% of the cost of qualifying property. The couple could spend $100,000 on land improvements (which qualify for 15-year depreciation and are eligible for bonus depreciation). These improvements would make them eligible for and $80,000 bonus depreciation deduction. Their tax savings would now be $28,800 ($120,000 * 24%).
Note that if the wife was self-employed and her income was above the QBI phaseout, being able to deduct rental losses may make her income eligible for the QBI deduction.
Many states also adhere to the tax professional status rental activity loss deduction, which increases tax savings.
Risks and Considerations
While there are benefits to being a Real Estate Professional, there are also certain drawbacks.
Because of the potential tax savings from being a Real Estate Professional, the IRS does tend to scrutinize returns for taxpayers claiming to a tax professional more often. The increased risk stems from the level of involvement and number of hours required to achieve the Real Estate Professional designation. It’s difficult for people with full-time jobs to spend the majority of their time in the real estate service industry.
While you can’t minimize the risk of an audit, you can maximize your chances of a favorable outcome through careful record-keeping. Careful time logs should be kept to demonstrate that you met the 750-hour requirement. The IRS counts the following activities towards the 750-hour requirement:
- Property development
- Construction and remodeling
- Property management
- Leasing or brokerage
The IRS Tax Court also requires that the long be kept contemporaneously. You can’t go back and recreate a log after the fact to verify your hours.
As with any business expenses, all expenses related to a Real Estate Professional business should be recorded and substantiated with receipts.
Being a Real Estate Professional offers valuable tax perks, from saving on capital gains (because they are not subject to NIIT) to reducing taxable income by being able to deduct rental losses.
While it can be tedious to obtain the Real Estate Professional designation, the tax benefits can make it worth it to put in the additional time to achieve the designation.
Q: Can I claim Real Estate Professional status if I have a full-time job in a different field?
It’s unlikely that you can meet the qualification of providing over 50% of your services in the real estate field if you have a full-time position. The IRS will likely take you to tax court if they are skeptical of claims that you work on your real estate more than 40 hours a week in addition to a full-time job.
Note that if you are on call as a physician, you are able to work on your real estate business while you are simultaneously working as a physician. This dual use of your time may help you qualify.
That being said, you are more likely to qualify if you have part-time job.
Q: If both my spouse and I participate in real estate activities, can we combine our hours to meet the requirements?
No. You cannot combine the hours that you and your spouse spend on real estate to meet the 750-hour requirement. However, as long as one spouse qualifies as a Real Estate Professional, you can use the deduction against ordinary income earned by either spouse.
Q: Do I need to qualify as a Real Estate Professional every year?
Yes. You must meet the requirements each year that you want to claim Real Estate Professional status.
If you were a real estate professional in a prior year and your losses created a net operating loss (NOL), the NOL is carried forward and can be used to offset your ordinary income in the current year.
Q: Does being a licensed real estate agent automatically qualify me as a Real Estate Professional for tax purposes?
No. You still must meet the active participation requirement, 750-hour requirement, and perform more than 50% of your services in the real estate industry.
Q: Must one become a licensed real estate agent to qualify for REPS?
No. Anyone who meets the material participation and primary professional activity criteria outlined above can qualify.