Maximizing Savings with Real Estate Professional Tax Status

Benefits

• Allows taxpayers to offset real estate losses against other nonpassive income.
  • Without this election, rental activities are typically considered passive, and losses can only be used to offset other passive income. If there is no passive income to offset, the losses are suspended and carried forward until there is passive income in a future year to take the losses against
  • The real estate professional election allows the taxpayer's real estate activities to be considered nonpassive.
• Provide relief from Net Investment Income Tax (3.8%)
  • Without this election, rental activities with net income are subject to NIIT, a 3.8% tax on passive income. This election provides relief from this tax on rental activities when making this election since the election allows for the activities to no longer be considered passive.
    
    

Understanding the IRS Criteria

To qualify as a real estate professional, you must meet three main criteria outlined by the IRS. The criteria are tested annually:

• Time: The first criterion involves meeting specific time requirements. You must spend more than 50% of your working time in real property businesses & spend at least 750 hours of service in real property trade or business.
  • Per IRC 469(c)(7)(C), a real property trade or business includes the following activities related to real estate:
    • Real property development
    • Redevelopment
    • Construction
    • Reconstruction
    • Acquisition
    • Conversion
    • Rental
    • Operation
    • Management
    • Leasing
    • Brokerage
  • Items that are specifically excluded from the time requirement:
    • Hours spent working as an employee unless the taxpayer is a 5% owner of the employer.
    • Hours spent merely as an investor reviewing financial data (in a nonmanagerial capacity).
  • Material Participation: The second criterion involves demonstrating material participation in each real estate activity (or under the election to group all real estate interests for purposes of determining material participation). The IRS has various nuances in determining material participation that should be discussed with your tax advisor.

Tips

Consider implementing the following initiatives:

• Maintain a detailed log: Keep a comprehensive log of the time spent on each real estate activity. This can include property management, property acquisition, research, networking, and other related tasks. The more detailed your records, the better you can support your claim in case of an IRS audit.
• Active involvement in decision-making: Actively participate in significant decisions related to your real estate investments. Attend meetings, respond to tenant concerns, and be involved in strategic planning for your properties, to name a few.
• Limit non-real estate activities: Ensure that non-real estate activities do not consume the majority of your working hours. Focus on maximizing your time spent on qualifying real property trades or businesses.
  
  

Additional Items to Note

The real estate professional election serves as a grouping of real estate related activities.

• The election does not allow exclusions of certain real estate activities from the election. If you are making the election, all of your real estate activities must be included in the election; therefore, you must thoughtfully consider the implications with your tax advisor.
• If you have significant suspended passive losses and are producing rental income, you may want to avoid making the election to avoid tying up those passive losses.

The election may only be revoked in a year where the taxpayer’s facts and circumstances have materially changed since the year the election was made.

Example

Taxpayer A works over 750 hours & spends more than 50% of their working hours in a real property trade or business. Taxpayer A does not have significant passive activity losses carrying forward from a prior year that they would want to release. Taxpayer A elects to group all their real estate activities together and meets the material participation requirements for that grouping. The taxpayer qualifies as a real estate professional and makes the election. Taxpayer A has a rental property with a net loss of $100,000 during the year. The taxpayer also has a real estate development business in which they materially participate, which nets $300,000 in income during the year. Under the real estate professional election, the rental property activity is no longer passive and can be netted against the real estate development income for a net of $200,000. Without qualifying for the real estate professional election, the $100,000 loss from the rental property could only be used to offset other passive activity income or carried forward until a future year when there is passive income to offset the loss.

Conclusion

Qualifying as a real estate professional with the IRS requires careful documentation, strategic planning, and active involvement in real estate activities. By meeting the material participation and time test criteria, you can unlock valuable tax benefits, allowing you to deduct losses from your real estate investments against other nonpassive income. Seek professional advice and maintain thorough records to ensure compliance with IRS regulations and maximize your tax advantages in real estate.

About the Author

Heather Shenk, CPA

Heather joined Trout CPA in 2020 after graduating from Messiah College with a Bachelor of Science degree in Accounting. She currently serves on the firm’s Construction & Real Estate, Consumer Services, Professional Services, and Multi-State Practice Groups. As a Senior Associate, Heather handles all aspects of tax planning and preparation for individuals and corporations for some of the firm’s significant clients. Heather lives in Lancaster County with her husband. She enjoys spending time with family and friends, hiking, biking, and gardening.