Real Estate Professional Tax Status
New investors often hear of the tax advantages of real estate. However, many of these same investors face disappointment when they realize that real estate losses generally don’t offset their other income. The real estate professional tax status solves this problem. For certain investors, this IRS designation allows passive real estate losses to offset active income – an incredible tax benefit.
We’ll use this article to outline the major considerations of real estate professional tax status. Specifically, we’ll cover the following topics:
- Real Estate Investments and Passive Income
- The Real Estate Professional Tax Status
- Qualifying as a Real Estate Professional
- Real Estate Professional Documentation Requirements
- Final Thoughts
Real Estate Investments and Passive Income
The IRS outlines three broad types of income: active, portfolio, and passive. And, how the IRS categorizes income dictates how it taxes that income. We’ve provided an overview of these income types below, from least to most beneficial from a tax perspective.
Active Income
This includes all earned income (e.g. wages, tips, and active business participation). For self-employed individuals, business earnings also qualify as active income. The IRS taxes this income at an individual’s marginal tax rate, currently ranging from 10% to 37%. Individuals need to pay payroll taxes (Social Security and Medicare) on this income, as well.
Portfolio Income
Investment income such as capital gains, interest, and dividends qualify as portfolio income. And, investors can generally only offset portfolio gains with portfolio losses. But, while people refer to stocks and bonds as “passive” investments, the IRS treats this income separately from passive income. Depending on its nature, the IRS taxes portfolio income either at the more advantageous rates of 0%, 15% or 20% or at an individual’s marginal tax rate.
Passive Income
The IRS states that this includes the income earned from rents, royalties, and limited partnership stakes. This income type significantly affects real estate investors. For most investors, real estate investment income qualifies as passive. This means that, in general, passive losses in real estate can only offset other passive income – not active or portfolio income.
The IRS taxes this income at an investor’s marginal tax rate. But, real estate investors also have the advantage of using depreciation – a cashless expense – to offset this income. This means that, while actual tax rates can be high, investors pay lower effective tax rates due to the effects of depreciation.
And, depreciation can often create a tax loss despite positive cash flow on a passive real estate investment. For example, assume an apartment building generates $50,000 in annual operating income. Ignoring debt service, if the property has an annual depreciation expense of $75,000, investors have a tax loss of $25,000 while still putting $50,000 in their pockets – a great outcome!
But, this situation also highlights passive loss limitations. As outlined, investors can typically only use passive losses to offset passive income. In this example, investors generally couldn’t use that $25,000 to offset active income like salaries or self-employment earnings. (NOTE: An exception to this passive loss limit allows certain investors with up to $150,000 in modified AGI to deduct up to $25,000 in passive real estate losses against active income).
These restrictions on passive losses limit the tax advantages of real estate investments. Most investors would need to set these disallowed tax losses aside. Then, they could use them in future tax years when they have passive income to offset. However, for certain investors, an opportunity – the real estate professional tax status – exists to deduct all passive losses from active income.
The Real Estate Professional Tax Status
Real estate professional is a formal IRS tax status. Simply working in the real estate industry does not make someone a real estate professional in the eyes of the IRS. Rather, people need to meet extremely detailed criteria to qualify. But, if they do, they can reap tremendous tax benefits.
As outlined, investors generally can’t offset active income with passive investment losses. For instance, an individual with $200,000 in W-2 wages couldn’t deduct $50,000 in passive real estate losses. The IRS refers to this as a passive activity loss (PAL) limitation. But, as stated, an exception exists for certain investors. If investors actively participate in a real estate investment (e.g. make rental decisions, approve maintenance expenses, etc), they may be able to deduct up to $25,000 in passive real estate losses from active income. But, this limit begins to phase out at a modified AGI of $100,000 and completely ends at $150,000, limiting its usefulness for many real estate investors.
But, real estate professionals face no passive activity loss limitations. They can use all of their passive losses to offset active income. Technically speaking, the IRS treats this income as nonpassive for real estate professionals. Continuing the above example, assume the individual making $200,000 in wages qualified as a real estate professional. If so, he or she could deduct the $50,000 in passive real estate losses against that $200,000, reducing taxable income to $150,000.
Qualifying as a Real Estate Professional
Clearly, for real estate investors, the real estate professional status provides incredible tax advantages. To avoid abuse, the IRS outlines detailed criteria that taxpayers must meet to qualify. According to the IRS, to qualify as a real estate professional, investors must meet both of these requirements in a given tax year:
- More than half of the personal services […] performed in all trades or businesses during the tax year were performed in real property trades or businesses in which [the investor] materially participated.
- [The investor] performed more than 750 hours of services during the tax year in real property trades or businesses in which [he or she] materially participated.
These definitions bring up a couple questions. First, what qualifies as material participation? This isn’t clearly defined, but the IRS outlines seven different tests to determine material participation. Most investors achieve this by participating in an activity for at least 500 hours in a given year.
Second, what does the IRS consider real property trades or businesses? The IRS also offers fairly broad guidance here, to include any of the following: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. However, the IRS clearly states that investors cannot count personal services performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. As a result, hours simply working for a company in the real estate industry do not count towards the above requirements.
Lastly, does the material participation requirement apply to each rental activity, or in total. In other words, if an investor owns four rental properties, does he or she need to prove material participation hours for each individual property? Fortunately, the IRS allows taxpayers to elect to treat all rental activities as a single activity. This drastically reduces the hourly material participation burden.
The IRS aptly summarizes the above in its Schedule E instructions: If [an investor was] a real estate professional for [a given tax year], any rental real estate activity in which [the investor] materially participated is not a passive activity. Therefore, losses from those rental activities can offset nonpassive income.
Real Estate Professional Documentation Requirements
The benefits of the real estate professional tax designation lead many investors to abuse it. Accordingly, the IRS reserves the right to audit a taxpayer’s documentation to verify that he or she has, in fact, met the requisite real estate professional criteria. And, upon an IRS challenge, the taxpayer bears the burden of proving that the IRS was incorrect in denying real estate professional status.
For this reason, taxpayers need to rigorously document their activities to demonstrate IRS compliance. According to the IRS, an individual taxpayer can demonstrate participation in any real estate activity by any reasonable means. While contemporaneous daily time reports or logs are not required, these items can provide the evidence necessary to prove real estate professional status during an IRS challenge. Bottom line, when it comes to documenting activity, it’s better to be safe than sorry. The more clearly investors document hours, the more likely they’ll withstand an IRS challenge of real estate professional status.
Final Thoughts
Real estate investing remains one of the surest strategies for building wealth. But, real estate investors need to understand the inherent tax limits of passive income – and the associated losses. However, for certain investors, qualifying as a real estate professional can be an outstanding tax strategy. With this designation, real estate investors can apply rental activity losses to active income, an incredible tax advantage.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associate tax implications.