Real estate is a great option for investors to generate passive income and build long-term wealth. Tax advantages are also a part of the perks of being a real estate investor. There are a number of options for reducing the taxes you’d normally pay on real estate income. However, there are further subtleties to how rental real estate revenue is taxed that regular investors may not be aware of. In the viewpoint of the IRS, becoming a designated real estate professional has a special tax advantage.
In this article, we’ll discuss the real estate professional status and how to qualify as a real estate professional for tax purposes.
Related: How to Qualify as a Real Estate Professional for Tax Purposes
What is a Real Estate Professional?
Rental real estate investors can always deduct expenses and depreciation from their rental income. If you have greater rental expenses than rental income, however, there are regulations that govern whether you can utilize the real estate losses to offset income from other sources.
According to the IRS passive loss rule, an individual cannot deduct losses from passive activities from their taxable income. As per the IRS passive income definition, rental real estate investing is considered a passive activity. Therefore, real estate losses cannot be used to offset W-2 wages. The IRS, however, makes an exemption to this regulation. Being a real estate agent makes you eligible for favorable tax treatment.
People with modified adjusted gross income (AGI) of below $100,000 are exempt from this passive activity loss limitation. As a real estate professional, you are not limited in your deductions. Under this special real estate professional status, IRS considers your real estate revenue to be nonpassive if you meet the requirements. As a result, whatever your income level is, you can deduct all of your real estate losses from your taxes.
How to Qualify as a Real Estate Professional for Tax Purposes
To qualify as a real estate agent for tax purposes, you must meet the IRS requirements and maintain documentation to prove that you meet them. The IRS has specific standards defining what is required to obtain the designation of a real estate professional.
To qualify as a real estate agent for tax purposes, you must meet both of these criteria:
1. At Least 750 Working Hours in the Real Estate Industry
To qualify for real estate professional status, you must spend at least 750 hours managing your rental portfolio during the tax year. These hours are only for work in the real estate industry. Overseeing repairs or improvements to a property, physically engaging in construction operations, promoting a property, and displaying and/or leasing your rentals are all activities that count toward the 750-hour criteria. Investing activities such as listing research do not count.
Moreover, you must have an ownership stake of at least 5% for each rental property for which you are claiming to be a real estate professional.
2. More than 50% Material Participation in the Real Estate Industry
You must materially participate in your real estate investments to achieve Real Estate Professional status. The real estate trade or firm in which you materially participate must account for more than half of your annual working hours. Therefore, if you work full-time, you won’t be able to qualify.
Material participation is earned by participation in activities such as active property management, acquisition, construction, reconstruction, or brokerage trade. You must perform these responsibilities on a continuous, regular, and significant basis. The IRS utilizes a 500-hour threshold to determine material participation.
As previously stated, hours spent on investment activities don’t count toward the 750-working hour threshold. However, they can be used to satisfy the Material Participation Test if you are directly involved in the portfolio’s day-to-day management.
Something to Note:
It’s vital to remember that the tax status for real estate professionals only applies to individuals, not organizations. Moreover, you and your spouse cannot combine your rental portfolio hours to meet the 750-hour minimum requirement. Both tests must be passed by one of you independently.
When Should You Become a Real Estate Professional?
Clearly, real estate professionals enjoy significant tax advantages. However, this does not mean that everyone should apply for IRS status. Consider the following circumstances before making a decision:
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You Own Rental Real Estate
The status of a real estate professional gives tax advantages for real estate investments, particularly if you have large rental portfolios. As a real estate professional, you may be eligible for large tax benefits if you own many rental properties.
Even if you can’t use the Real Estate Professional certification to offset all of your income, you may certainly use it to offset a significant portion of it. However, if you own only one rental property, your efforts may be in vain. In reality, a single rental property may not create sufficient losses to warrant this real estate professional status.
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You Don’t Have a Full-time Job
You’ll find it easier to achieve the real estate professional qualification standards if you don’t have another full-time work. In the real estate sector, any personal services you provide will be your only personal services. As a result, it will be easier to for you to complete the 750-hour requirement. This designation is taken seriously by the IRS, and those who appear unlikely to achieve the level will be audited.
In other words, if you make a lot of money as an actively practicing professional, the IRS will find it suspect that you will also are able to spend more than half of your time managing your real estate assets. Most persons who work full-time are immediately disqualified.
Related: Can I Invest in Real Estate With a Full-Time Job?
Tips to Qualify As a Professional
Earning Real Estate Professional status has numerous advantages, but it is a difficult distinction for one to obtain. Here are a few tips to help you qualify as a real estate professional.
1. Take on More of the Day-to-Day Portfolio Management
Take over more of the day-to-day management of your real estate portfolio. The time spent on this could soon push you over the required minimum.
2. Work Part-Time
If you are working part-time or could do so, consider how many hours you spend working and whether you could spend more than half of your free time managing your real estate holdings.
Related: The Ultimate Real Estate Investment Strategies for Part-Time Investors
3. Involve your Spouse
If you already have a full-time job, you can have your spouse apply for the position. Of course, your partner has to actually do the work, not simply claim they’ll do it. Make sure your partner is on board with this plan. You’ll want to go over the IRS criteria carefully and make sure they are willing to take on this time-consuming responsibility.
4. Keep Detailed Records
The IRS wants to make sure you qualify as a real estate professional because of the significant tax benefits. Therefore, they will audit your real estate documentation on a regular basis for enforcement purposes.
For this reason, it’s vital that you keep track of your working hours. You’ll need supporting paperwork to show that you worked 750 hours and met the higher-than-50-percentage-point criterion. You can do this by keeping detailed records of your time spent working in real estate and the tasks you completed. This is particularly significant for investors who work in fields other than real estate.
The Bottom Line
If you meet the IRS’s requirements, you can qualify for real estate professional status, which comes with a slew of tax benefits. If you are thinking of how to become a real estate investor and want to maximize your income, you should consider acquiring the real estate professional status to take advantage of all the available real estate agent tax deductions. To get started on the right foot, be sure to work with a qualified and experienced tax professional.
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