Real estate is an asset that gives the landlord an edge over aspects such as inflation while acting as a generous source of revenue. In addition, investing in real estate property provides tremendous tax advantages that other types of investments cannot match. For example, these investors are sometimes exempted from taxes on rental income, which they then use to offset other types of income like business profits.
Many opt to invest in passive real estate through real estate syndications and investment trusts (REITs). However, some investors prefer to be hands-on, selecting their own properties and overseeing renovations. Real estate professional (“REP”) status enters the picture in this situation. You can continue to deduct losses from your income without being liable to an income cap in case you claim this designation on your taxes.
Simply put, having the IRS designation of real estate professional indicates that you own and regularly work in a real estate business. Therefore, you can claim the total loss resulting from your rental real estate projects as non-passive as long as you meet the requirements for real estate professionals and substantively participate in rental activities.
Investing in Passive Real Estate
An investor who does not materially participate in the acquisition, disposition or management of the real estate is known as a passive investor. This implies that you, the investor, can make a passive investment in real estate through a fund manager or sponsor who manages the day-to-day management of the asset or investment portfolio.
Popular passive real estate investments include real estate syndications, in which investors pool their money to buy a specific investment property. REITs and real estate funds are examples of passive investments.
Another definition of passive investing includes people who do not engage in real estate-related activities for a sufficient number of hours each year to claim it as their primary occupation.
Passive activity loss regulations apply to such passive investors. Because of this inactivity, you cannot deduct losses from your real estate investments into your regular income. Instead, losses are accumulated for investment and taken out only when you manage to sell the property successfully. In simple words, these losses are not lost but deferred until further notice.
Investing in Active Real Estate
When you think of real estate investing, you probably picture active real estate investing, where you buy a property and rent it out or sell it for a profit. However, in reality, things are a lot more different and complex.
Investors in active investments are in charge of locating investment properties, securing financing, and maintaining the property either on their own or through the employment of a property management company. In contrast to passive investing, active investing is much more hands-on and calls for in-depth knowledge of the real estate asset class as well as a lot more time.
According to the IRS, those who materially contribute to the real estate business management or who are consistently and significantly involved in business operations are considered active investors. You should own at least 10% of the rental property under consideration and take a significant role in management decisions to be regarded as an active investor. This distinction is crucial because active investors can deduct real estate investment losses from their regular income as opposed to passive investors.
You may be exempted from the active investor income restrictions and the passive loss rules if you claim and prove that your taxes have the designation of a real estate professional.
How to Qualify as a Real Estate Professional
So, now that we know what a ‘real estate professional’ is, let us look at the qualifications and experience you need to attain this title. We are telling you in advance that although the process may appear challenging initially, it is definitely worth the hassle and effort.
The IRS considers you a real estate professional if you manage rental properties, invest in real estate, make material contributions and work in a real estate business. It is mandatory that your working period in the real estate industry is longer than any other job you have done to earn the status of a real estate professional.
To earn the tag of a real estate professional, you must devote at least 50% of your personal time to the real estate industry. You cannot claim this status while working a full-time job but are permitted to work on a part-time basis as long as you can demonstrate, through an audit, that more than 50% of your time was spent materially advancing your real estate business.
Moreover, an active engagement of more than 750 service hours per year is required in either real estate or business management industries. (In this case, a week would consist of about 15 hours.)
Your investments must also have material participation. According to the IRS’s regulations, you should be personally involved in the construction, development, leasing, and other related operations concerning a real estate business. This doesn’t necessarily mean serving as the property manager. You can still invest in syndications and other passive investment vehicles, but they won’t contribute to your 750 hours for REP status.
It is possible to claim REP status without a license or certificate because it is solely based on your work during the tax year. However, due to the ambiguity of the tax code and the legislation governing REP status, there has been a great deal of litigation on these topics. Keep a detailed log of the time you spend working on your real estate business if you want to apply for REP status so you can prove it during an audit.
Can You Work a Full or Part-Time Job and Still Be Qualified as a Real Estate Professional?
Let’s clear up one thing: anyone with a full-time job will find it extremely difficult to qualify as a real estate professional. Even though it’s not entirely impossible, it’s still highly unlikely to manage another job while working as a real estate professional. Until now, we haven’t encountered a tax court case where a taxpayer successfully established their status as a real estate professional while holding down a full-time job.
Despite this statistic, it is still possible to accomplish both things if you adhere to a strict and demanding working routine. Keep a record of your regular activities containing time logs, notations, emails, invoices, appointments, and credit card and bank transactions as credible evidence of your dedication to the real estate business. You will also need to present character witnesses in the IRS and Tax Court to convince the judge about your outstanding work ethic and get your story accepted.
What Does “Real Estate Trade or Business” Mean?
Unsurprisingly, there are some ambiguities in the regulations governing what counts as real estate business activity. In accordance with IRS code section 469(c)(7)(C): all construction, rental, procuring, and leased real properties fall under the heading of “real property trade or business.”
Property management companies will fall under the “management” category mentioned above. As a property manager, you are engaged in a real estate trade or business, and the hours you spend doing so will count toward the 750-hour test and the “more time in real estate than anywhere else” test.
Education, research hours, and infrequent travel time are frequently disregarded in these scenarios. However, time spent working in and on your property management company will generally count toward the two tests required to become a real estate professional. One basic principle of this designation is that the burden of proof is on you, the real estate investor, not your accountant, to demonstrate that you qualified in the tax audit.
Tax Deductions for Real Estate Professionals
Qualifying as a real estate professional can result in significant tax advantages. Your rentals will be considered “non-passive” if you meet the criteria as a real estate professional and participate materially in your own rental activities. This means that your rental losses can be used to offset your other income indefinitely. Rental losses are typically passive and can only be offset by passive income.
Because landlords often do not have enough passive income to absorb the entire amount of passive losses, the excess rental losses are “suspended” and carried forward. But, if you are a real estate professional who actively participates in your own rental operations, these rental losses are non-passive for you and usable to offset all types of income.
Real Estate Professional Status Challenges
The IRS closely examines taxpayers who assert REP status. Remember that the 50% test restricts REP status to those who work primarily in real estate; attempting to qualify as a REP while working full-time will raise red flags.
Keep track of your hours and activities in case you are audited. The more specific and meticulous you are, the better. Consider using a different email address for your real estate business so that you can quickly locate correspondence records. Time-tracking apps for freelancers can also help manage your time.
To determine whether REP status is right for you, consult qualified professionals such as your financial advisor, CPA, and possibly an attorney. If you do not yet meet the required standards, they can assist you in charting a course to strengthen your business. And if you meet the criteria, they can help you get organized so that compliance is never a problem.
It might not seem very easy at first glance. Still, we hope that this article has clarified the basics of REP status to you and given you enough insight to plan the next steps you need to take to earn the reputable title of a real estate professional from the IRS’s perspective.
