Being a real estate professional has one main tax advantage: the ability to deduct losses against your active income up to $250,000 if you are single and $500,000 if you are married. With this exalted status comes some rules and restrictions that the investor must carefully consider (with the consultation of a CPA). In this article, I will explain what a real estate professional is, what the requirements are, and go through an example to show the impact it can have on your taxes.
Key Terms
Material Participation - You are considered materially participating if you are involved in the operations of an activity which is regular, continuous, and substantial. See 7 tests below.
Real Property Trades or Businesses that qualify for being a real estate professional:
- Development
- Redevelopment
- Construction
- Reconstruction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage
Requirements to be a Real Estate Professional
To be a real estate professional, one person needs to meet the below tests. If you are married, this still applies and only one person’s time can be counted for the below.
50% of your time in real property businesses (described previously in above key terms) in which the taxpayer materially participates
More than 750 hours during the year in real property businesses in which the taxpayer materially participates.
Example:
Spouse A is a high earning professional with a demanding work schedule. Spouse B is a stay at home parent. For Spouse A to qualify, they would need to work more than their job (2,080 hours a year). This is unlikely given their situation. Spouse B does not have a job. Therefore, in the IRS’ eyes, any time would need to be spent towards rental activities would accomplish test #1. Spouse B spends 800 hours per year managing the rental properties. As such, this couple would qualify for being a real estate professional since Spouse B met the requirements.
What Hours Do and Don’t Qualify For Being A Real Estate Professional
This guide states what does and does not count in terms of hours. Please scroll down to section 10. It is a good starting point. This guide also has a lot of other useful information that would benefit any investor to read.
Further, time spent as an employee in a real property trade or business, does not count unless the employee owns more than 5%.
Best Practices For Logging Your Time
You need to keep contemporaneous time logs. What this means is that every day or two, you go back and track the hours of the previous day and keep track of your real estate hours. I’d reference the above guide for seeing if your activity qualifies. I’d recommend keeping this in some type of spreadsheet and keeping detailed notes of each activity and upload supporting documentation into a separate folder.
Further, it is also best practice to log your non-real estate hours. You will need to prove that you worked more than 50% of your time. The best way to do this is to show what you did with your non-real estate hours as well.
Material Participation
There are seven tests that come directly from the tax code. You only have to meet one of the below tests to qualify as a material participant. They are:
The individual participates in the activity for more than 500 hours during such 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 (within the meaning of paragraph (c) of this section) for the taxable year, and the individual's aggregate participation in all significant participation activities during such 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 (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or
Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
Other Considerations With Material Participation
Married? It’s a Team Game
If you are married, you may count your spouse’s time towards that activity as well.
Example:
Let’s say spouse A spends 200 hours on their rentals, they would not qualify themselves. Now, let’s count Spouse B’s time. Spouse B spends 305 hours on their rentals. As such between the two spouses, they would meet the first material participation test listed above.
Groupings
If you just have to meet this requirement for each rental property you had, it’d be extremely difficult to do. As such, you may need to group these activities together to get the losses from the rental properties to become a material participant. However, this may freeze the passive losses that may have built up prior to becoming a real estate professional. This is also a binding election for future years as well.
Example:
Through 2015-2020, Anthony purchased five properties (all four unit properties). During these years, he has made more than $150,000 to qualify for the deduction for small landlords (discussed in the tax impact section of this article. As such, these losses were passive losses. In 2021, he had a lifestyle change and became a real estate agent and made significant income and qualifies to be a real estate professional (meets the two tests and material participation). In 2021, he’d be able to deduct the losses for 2021 ($15,000). However, in 2022, he sells an underperforming property for a $10,000 loss after factoring in all expenses. Not only would he not be able to deduct that loss in the year of sale (since it’s grouped as part of an activity), he also would not be able to deduct the suspended losses from 2015-2020 for that specific property.
Case Studies
Example 1: Non-real estate professional with high incomes
Spouse A makes $280,000 and is not interested in real estate. Spouse B makes $100,000 and is interested in real estate. In their current portfolio, they have 15 rental properties that they self manage. They all cash flow nicely and produce a combined taxable loss of $50,000 annually. At present, since they do not make under $150,000, these losses get suspended for future years. Spouse A and B are paying tax on $380,000 of income.
Example 2: Real Estate Professional with high incomes.
Spouse A makes $280,000 and is not interested in real estate. Spouse B decided to leave their job before year end to pursue real estate full time. They were previously making $100,000. In the following year, after discussion with their CPA, Spouse B realized that they would qualify for being a real estate professional. They have 15 properties that produce a $50,000 loss annually. Further, Spouse B decided to purchase a multi-family property in the current year for $500,000 and utilize a cost segregation study (breaking the building into its component pieces). In year 1, the benefits would produce a deduction of $100,000. As such, Spouse A and B would have real estate losses of $150,000. Instead of paying taxes on $280,000, they now pay taxes on $130,000.
Wrapping It Up
There are two tests to qualify for being a real estate professional: more than 750 hours and half your time. With becoming a real estate professional, you don’t automatically get to deduct losses. You can take losses if you materially participate in your activity. You may group your real property trade or businesses as well (discuss this with your CPA). Overall, there can be some significant tax advantages (the ability to deduct $250,000 in rental losses against active income if you’re single or $500,000 if you’re married). You will certainly want to discuss this with your CPA to see what additional input they offer. This is a highly enforced area in the tax code and you want to make sure you and your CPA are on the same page to maintain compliance.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at aaronz@thethinkers.com.
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