Qualifying as a real estate professional means that you are allowed to deduct your passive losses from your ordinary income and that there are no limitations to the amount of loss you can deduct in any one year. Most real estate investors, however, do not qualify for this beneficial tax status as it requires you to meet two key criteria.
To qualify as a real estate professional you must:
In this article, we take a look at the benefits that come with qualifying as a real estate professional and how you can determine if you qualify or not.
According to the IRS, there are three classifications of real estate investors.
The category with the least amount of benefit to the taxpayer. Only the ability to deduct passive losses against passive gains is offered.
This classification allows the taxpayer to deduct up to $25,000 of passive losses against the typical income. However, this deduction is not available upon meeting the Adjusted Gross Income (AGI). For a married couple who have filed jointly, this is $150,000 and for an individual – AGI is $100,000.
A real estate professional is eligible for 100% of all passive losses against their typical income. However, being deemed a real-estate professional does not immediately grant the ability to offset all losses.
Passive losses are only able to be offset by passive income. The main perk of deducting passive expenses is that it will decrease your tax liability.
There are a set of criteria, outlined by the IRS, that is needed to approve this benefit. Proving material participation is one of the criteria needed to achieve this perk.
Material participation can be approved by the IRS under two specific requirements.
Over 50% of the hours worked must be in real estate businesses. For example, a person who works 500 hours a year in a non-real estate industry will need to perform at least another 500 hours within the real estate business to qualify.
The next part of this rule stipulates that 50% or more of the real-estate-related services must have material participation. The term, ‘materially participate’, as defined by the IRS, is the method of determining one’s active or passive participation in a business venture. The main test of being materially participant is working more than 500 hours in a real estate business over the course of the year.
Investor hours do not count towards the 50% rule. This includes activities such as financial statement reviews, investor report preparation, researching new property, and general finance reviews.
There are several tests used to determine whether someone’s actions qualify as 50% material participation.
Tests for material participation Include:
When aiming for a 750-hour requirement, the previous 500 hours of material participation assists this greatly. Much like the previous rule, all hours that go towards tax deductions must be in the real estate business.
Real estate investors will need to prove that they have completed the hours required with supporting documentation. You can use software like Landlord Studio to keep track of the total number of hours worked in a real estate business.
While Landlord Studio doesn’t have an hour tracker, you can use the mileage tracker. This allows you to record the date of the activity, the time spent, the location and purpose of the work, and any additional notes. At the end of the year, you can then simply generate a report to calculate the total number of hours worked as a real estate professional. Additionally, you can upload any supporting documentation and store it securely and organized in the system for reference at a later date.
In the event the owner has more than one rental, they can aggregately elect all real estate businesses as a single activity. This makes it easier to gather and track the total hours spent in a qualifying activity.
If the properties are not elected as a single activity, then the 750-hour requirement will need to be met for each business. Qualifying one rental does not guarantee the other properties are a single activity.
Although this makes it simpler and easier to build up the required number of hours, problems can arise if one of the properties that form part of the elected single activity is sold. As such, it is recommended that you consult with a qualified CPA or financial planner when deciding whether or not to elect all properties as a single activity.
Qualifying as a real estate professional means there is no limits set on the amount that can be deducted in a single year. Additionally, losses from your real estate business can be deducted against other income sources. As such, qualifying as a real estate professional can heavily reduce your tax liability.
To wrap it up in a relevant example, let’s look at James.
James is a real estate agent who has spent 1300 hours representing his clients in both purchase and sale transactions. For tax purposes, James qualifies as a real estate professional.
Alongside his day job, James also has a rental property that harvests a $10,000 loss. He can’t utilize this as a deduction as he earns over $150,000 a year. It’s not enough that James has the hours, he must now prove he materially participates in the management of his rentals in order to qualify as a real estate professionals and be eligible for the unlimited deductions.
Luckily for James, he kept contemporaneous records of his hours of active participation in the property to use when he substantiates his real estate professional category claim.
Whilst qualifying as a real estate professional does come with tax benefits, doing so isn’t always easy. In order to maximize your tax deductions, you need to employ good systems and software to keep accurate and detailed records not only of each and every deductible expense but of the hours spent in material participation of your properties.
Finally, it’s always worth discussing this with a licensed CPA or accountant in order to ensure you are keeping all the required records and remain compliant with the relevant laws and regulations.
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