A Real Estate Professional Illustration

Real Estate Professional Status For Tax Purposes: How to Qualify

Key Points

  • Individuals must meet a number of tests to qualify for a real estate professional status (REPS).
  • Real estate professionals might be able to exclude rental income from the net investment income tax and deduct rental activity losses against active income.
  • Proper documentation is critical to substantiate your claim of being a real estate professional.

Table of Contents

  1. Who is a Real Estate Professional?
  2. Real Estate Professions That May Qualify for REPS
  3. Net Investment Income Tax and REPS
  4. Rental Activities Losses and REPS
  5. Grouping Election for Rental Real Estate Activities
  6. Real Estate Professional Documentation
  7. Summary

Are you a real estate professional? Maintaining real estate professional status (REPS) can provide relief from the 3.8% net investment income tax and allow you to deduct rental property losses against ordinary income.

However, there are some caveats to being a real estate professional, especially in the participation and documentation requirements. In this article, we’ll explore the fundamentals of real estate professionals, covering all of the tax implications you need to be aware of.

1. Who is a Real Estate Professional (REP)?

A real estate professional (REP) is an individual who spends most of their time completing real estate activities. To qualify as a real estate professional, you must meet a four-part test:

  1. Spend more than 50% of your time in real property trades or businesses.
  2. Perform more than 750 hours of service in real property trades or businesses.
  3. Materially participate in each rental activity you hold.
  4. The minimum of 5% ownership interest in each activity

Time and Hours Test

The time and hour requirements are based on a full calendar year. This means you spend about half your week or at least 15 hours working on real estate activities.

Material Participation Test

Material participation is further defined by the IRS in Publication 925. If you satisfy any of the following conditions, you materially participate in the activity:

  1. You log more than 500 hours during the year.
  2. Your participation made up a majority of the participation in the activity, including those without an ownership interest.
  3. You participated in the activity for more than 100 hours during the year, and you participated as much as any other individual, including those without an ownership interest.
  4. The activity is a significant participation activity, and you maintained significant participation for more than 500 hours during the year.
  5. You materially participated in the activity for 5 out of the last 10 tax years. Participation years do not need to be consecutive.
  6. If the activity is classified as a personal service activity, you participated for 3 of the preceding tax years. Rental real estate is not considered a personal service activity.
  7. You participated on a regular, continuous, and substantial basis during the tax year. If someone else, like a property manager, were paid to manage the property, you would not materially participate if you logged less than 100 hours.

If you meet any of these requirements, you have materially participated in the business and satisfy one of the four criteria for being classified as a real estate professional.

Greater-than-5% Owner Test

If an individual is an employee and works for an employer (such as a real estate company), the hours spent as an employee typically do not count towards meeting the one-half time and 750-hour tests required to qualify for Real Estate Professional Status.

However, there is an exception for individuals who own more than 5% of the employer. In other words, if the individual is a greater-than-5% owner in the real estate business where they are employed, their hours as an employee may count toward meeting the qualification criteria.

2. Real Estate Professions That May Qualify for REPS

Real estate professionals aren’t limited to agents. Sec. 469(c)(7)(C) provides, “the term ‘real property trade or business’ means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” Various professions within the real estate industry may potentially qualify for this status. Here are some examples:

  1. Real Estate Agents/Brokers: Individuals engaged in buying, selling, and leasing real estate on behalf of clients.
  2. Property Managers: Professionals responsible for managing rental properties on behalf of property owners.
  3. Real Estate Developers: Those involved in acquiring, developing, and selling real estate, including residential or commercial properties.
  4. Real Estate Investors: Individuals actively involved in the acquisition, management, and sale of investment properties.
  5. Construction Professionals: Individuals engaged in construction, development, or renovation projects related to real estate.

3. Net Investment Income Tax and REPS

One of the advantages of having REPS is the ability to exclude rental income from the net investment income tax. Under this regulation, certain income, like dividends, interest, and rental income, are taxed at a rate of 3.8% once your adjusted gross income exceeds $250,000 for married filing joint taxpayers and $200,000 for single and head of household filers.

There are some limitations to the exclusion. For one, you must meet the four-part test to be classified as a real estate professional. Second, the rental income needs to be derived in the ordinary course of a trade or business. Third, the rental activity must be nonpassive.

If you meet these requirements, you can generally exclude your rental income from the net investment income tax.


Case 1:

Facts:
  • Peter works full-time as a real estate agent and broker at PJ Realty
  • His wife Jessica is a 50 % owner with Peter in PJ Realty
  • PJ Realty is a successful business and brings $500,000 in net income
  • Over the years, Peter and Jessica acquired a couple of rental properties
  • Property A generates a monthly lease income of $12,500
  • Property B generates a monthly lease income of $7,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $70,000 for each property
  • Peter meets all the tests and qualifies as a real estate professional
Issue:

How can REPS help Peter reduce his taxable income and pay less tax?

Calculations:
Result:

Peter can take a full loss from Property B because income from Property A was able to absorb the loss from Property B. Their adjusted gross income is above the threshold, and their rental income is $70,000. By qualifying as a REP, Peter saves $2,660 in net investment income taxes.


4. Rental Activities Losses and REPS

Real estate professionals also have benefits when it comes to losses.

In general, rental activities, where payments are primarily for the use of tangible property (such as rental properties), are inherently classified as passive activities. Under this rule, you can offset losses from passive activities only by income from other passive activities. Therefore, you cannot offset the income from non-passive activities, such as wages or business income from active participation.

Under the REP exception, qualifying individuals can use losses from rental real estate activities to offset other income without the usual passive loss limitations.


Case 2:

Facts:
  • Peter works full-time as a real estate agent and broker at PJ Realty
  • His wife Jessica is a 50 % owner with Peter in PJ Realty
  • PJ Realty is a successful business and brings $500,000 in net income
  • Over the years, Peter and Jessica acquired a couple of rental properties
  • Property A generates a monthly lease income of $12,500
  • Property B generates a monthly lease income of $7,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $70,000 for each property
  • Peter meets all the tests and qualifies as a real estate professional
  • NEW Property A renter moved out early in a year, and Peter was able to collect only 4 months of rent
  • NEW Property A was available and advertised for rent for the rest of the year
Issue:

How can REPS help Peter reduce his taxable income and pay less tax?

Calculations:
  • Net loss from Property A is ($20,000) [$12,500 x 4 months – $70,000]
  • Net loss from Property B is ($10,000) [$5,000 x 12 months – $70,000]
  • Net loss from both activities $30,000 [-$20,000-$10,000]
Result:

Peter can take a full loss from Properties A and B because PJ Realty’s income was able to absorb the rental losses.


Earning a REPS and holding rental property opens the door to losses that nonprofessionals can’t take.

5. Grouping Election for Rental Real Estate Activities

If you have several rental activities and you don’t meet the material participation rules for any single activity, the grouping election under IRC Section 469(c)(7)(A) might be something to consider. This election allows an individual to treat multiple rental real estate properties or interests as a single activity for the purpose of determining whether the taxpayer materially participates in the combined rental real estate activity.

Here are the key points related to the grouping election for rental real estate activities:

Criteria

Before making the election, a taxpayer must meet the qualification of REP. This involves performing more than half of personal services in real property trades or businesses, materially participating in these activities, and spending over 750 hours providing personal services in real property trades or businesses during the tax year.

Economic Unit Determination

The election allows the taxpayer to group certain real estate activities together, treating them as an “economic unit”. To determine an economic unit, factors like similarities of the business, common control, common interest, geographic location, and interdependence of the activities are considered. The grouping should form a cohesive economic unit.

Filing Election

The election is a separate statement attached to the tax return filed for the year you meet the criteria. Once you make the election, it’s generally irrevocable except for specific circumstances.

Pros of Making the Election:

Upon making the election, current and suspended losses that would have been restricted by passive activity rules become deductible as expenses. This can lead to more favorable tax treatment for all activities included in the grouping.

Cons of Making the Election:

While the election offers benefits, it comes with certain disadvantages. Prior year suspended passive activity losses remain unavailable for deduction, and only losses incurred from the year of the election onward can be utilized. Additionally, if one activity from a grouped set is sold, the prior year’s suspended passive losses from that specific property will not be released until all activities in the group are sold.


Case 3:

Facts:
  • Peter works full-time as a real estate agent and broker at PJ Realty
  • His wife Jessica is a 50 % owner with Peter in PJ Realty
  • PJ Realty is a successful business and brings $500,000 in net income
  • Over the years, Peter and Jessica acquired a couple of rental properties
  • Property A generates a monthly lease income of $12,500 for the first 4 months
  • Property A was available and advertised for the rest of the year
  • Property B generates a monthly lease income of $7,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $70,000 for each property
  • Peter meets all the tests and qualifies as a real estate professional
  • NEW Peter is not able to meet material participation in each rental activity, and therefore, his rental activities are passive
  • NEW Their CPA did not educate him about the grouping election, and their tax return was filed without it
Issue:

How does failing to meet REPS affect Peter’s taxable income and tax liability?

Calculations:
  • Net loss from Property A is ($20,000) [$12,500 x 4 months – $70,000]
  • Net loss from Property B is ($10,000) [$5,000 x 12 months – $70,000]
  • Net loss from both activities ($30,000) [-$20,000-$10,000]
Result:

Peter can’t take a loss from Properties A and B because the losses are passive. Peter will report $0 income/loss from his rentals and carry forward Property A’s $20,000 loss and Property B’s $10,000 loss to future years until the net rental income is created or properties are sold.


Case 4:

Facts:
  • Peter works full-time as a real estate agent and broker at PJ Realty
  • His wife Jessica is a 50 % owner with Peter in PJ Realty
  • PJ Realty is a successful business and brings $500,000 in net income
  • Over the years, Peter and Jessica acquired a couple of rental properties
  • Property A generates a monthly lease income of $12,500 for the first 4 months
  • Property A was available and advertised for the rest of the year
  • Property B generates a monthly lease income of $7,500
  • This year, Property A and Property B incurred various annual expenses, adding up to $70,000 for each property
  • Peter meets all the tests and qualifies as a real estate professional
  • NEW Peter is still not able to meet material participation in every single rental activity.
  • NEW Peter is able to aggregate his hours from both rental activities and meet material participation in the combined rental activity, and therefore, his rental activities are non-passive
  • NEW Their new CPA filed their tax return with the grouping election
Issue:

How can REPS and grouping help Peter reduce his taxable income and pay less tax?

Calculations:
  • Net loss from Property A is ($20,000) [$12,500 x 4 months – $70,000]
  • Net loss from Property B is ($10,000) [$5,000 x 12 months – $70,000]
  • Net loss from both activities ($30,000) [-$20,000-$10,000]
Result:

Peter can take a loss from Properties A and B because PJ Realty’s income was able to absorb the rental losses.


Case 5:

Facts:
  • Peter works full-time as a real estate agent and broker at PJ Realty
  • His wife Jessica is a 50 % owner with Peter in PJ Realty
  • PJ Realty is a successful business and brings $500,000 in net income
  • Over the years, Peter and Jessica acquired a couple of rental properties
  • Property A generates a monthly lease income of $12,500
  • Property B generates a monthly lease income of $7,500
  • Property A and Property B incurred various annual expenses, adding up to $70,000 for each property
  • Peter meets all the tests and qualifies as a real estate professional
  • NEW Continuation of case 4
  • NEW It’s the following year
  • NEW Peter found a new renter for Property A who paid $13,000 each month this year
  • NEW Property A unallowed loss carryover from previous years ($20,000)
  • NEW Property B unallowed loss carryover from previous years ($10,000)
Issue:

How can REPS and grouping help Peter reduce his taxable income and pay less tax?

Calculations:
  • Net income from Property A is $86,000 [$13,000 x 12 months – $70,000]
  • Net loss from Property B is ($10,000) [$5,000 x 12 months – $70,000]
  • Net income from both activities $76,000 [$86,000-$10,000]
  • Net income from both activities utilizing Property A unallowed loss carryover from previous years $56,000 [$76,000-$20,000]
Result:

Peter can take not just the current year’s loss from Property B because income from Property A was able to absorb the loss from Property B, but also Property A’s suspended loss of $20,000 from the previous year.


6. Real Estate Professional Documentation

Documentation of your real estate activities is crucial to support your position. This means if you are claiming to be a real estate professional, you need to have comprehensive documentation procedures in place. Here are a few tips:

  • Support for the rental income and expenses you are claiming on Schedule E. If your return is audited because of passive activity losses, you need to be able to substantiate the losses you are claiming.
  • Comprehensive records on hours worked inside of your real estate business, including dates, the tasks performed, and the time spent.
  • Details of time spent working on activities outside of your real estate business, including dates, the tasks performed, and the time spent.
  • Records that show accurate data, not estimates or unverified data. There are countless time-tracking software apps available to help you track data. 

These are just a few of the procedures you should put in place as a real estate professional. The more documentation and precision you have in your records, the better. You don’t want to be scrambling to prove your status to the IRS in the event of an audit.

7. Summary

In conclusion, qualifying for Real Estate Professional Status can provide substantial tax advantages for those deeply entrenched in the real estate industry. By understanding the requirements, maintaining diligent records, ensuring material participation, and seeking professional advice, real estate professionals can navigate the complexities of tax codes to their benefit. Remember, the effort you put into qualifying for REPS could result in significant savings, making it a worthwhile endeavor for those looking to maximize their real estate investments.

For more information surrounding rental property taxation, accounting tips, and tax tricks, check out our other posts.


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