A Doctor’s Primer On Real Estate Professional Status
It seems like real estate investing has become the “hot” investment among doctors and other high-income professionals these days. Why? Many are becoming gun-shy of the volatile stock market and want diversification.
Others are sick of paying Uncle Sam half of their check each month and are looking for tax advantages.
How about you? Do you fall into either of these categories? I don’t know too many people that want to continue receiving a HUGE tax bill each year. Myself included.
One of the top questions I get asked from members of the Passive Investors Circle is:
“Will investing in passive real estate syndications lower my practice income?”
The only income that investing in syndications lowers would be the passive income it produces and NOT your practice’s income.
Related article: How Is Passive Income Taxed
But there’s also something out there that could help doctors significantly reduce their tax burden called Real Estate Professional Status (REPS).
Have you ever heard of this? Most haven’t. But if you’re already a real estate investor like myself, then using this designation could potentially save you a huge amount of dinero when it comes to paying taxes.
Interested? Let’s begin…..but first a disclaimer.
[Disclaimer: I’m not an accountant, lawyer or financial advisor. This article is informational only. Please consult your own team of professionals about the topics covered here today.]
Going, Going, Gone…
Dentists and physicians alike have very few tax advantages.
Unfortunately, many of the tax deductions that most people get are in the lower income brackets keeping us from benefiting from them.
As an example, most deductions begin to phase out the higher the income made. You may have encountered this when attempting to deduct student loan interest.
Here’s how I felt when I tried this: “Sorry, we’re going to punish you because you trained and sacrificed and had to take on student loan debt in order to do so but wait, you now earn too much so no deductions will be allowed.”
As a side note, when we reached debt-free status, most of our practice’s deductions were phased out leaving us with a HUGE tax bill. So much for enjoying being debt-free!
Passive Real Estate Investing
The majority of the Passive Investor Circle members are too busy to become an active real estate investor and for that reason, focus on investing in passive real estate.
The definition of a passive investor is someone that does NOT “materially participate” in the buying, selling, or management of properties.
A popular type of passive investment (that we invest in) are called real estate syndications.
These allow the passive investor to pool their money with others (plus the sponsor who handles the day-to-day property) to purchase an asset (i.e. apartment building) that they couldn’t normally do so on their own.
Other examples of passive investments are:
- Real estate funds
- Real Estate Investment Trusts or REITs
As stated earlier, these types of investors are subject to passive activity loss rules. This means if your real estate investments generate losses, you’re NOT able to deduct those against your practice’s income.Join the Passive Investors Circle
Passive investment example
Most syndication deals are for accredited investors only which allows the majority of doctors to qualify for due to a high income.
The minimum investment for most of the deals that we’re currently in is $50K. If you invest in a deal then you can expect to receive a K-1 tax form annually.
If a particular deal that you’re in generates a $20,000 loss from depreciation, you can’t offset that $20,000 against your W-2 or practice income.
However, you can offset that loss against any passive gains you have in the current tax year. Most of these will be used against your monthly/quarterly distributions your investment spins off.
Active Real Estate Investing
When I first made it a point to begin the process of acquiring streams of passive income, real estate investing was one of my first choices.
At that time, I thought that in order to get into real estate, I had to become a landlord. As you can imagine, I wasn’t too thrilled with the thought of getting a second job. For me, practicing full-time along with being a husband and dad puts plenty on my plate.
But back then I was clueless about other options available. I thought that I wanted to buy a handful of single family homes and eventually pay them off to reap the benefits of the cash flow rolling in.
As an active investor, you’re responsible for:
- finding investment properties
- acquiring financing
- managing yourself or hiring a firm
- marketing vacancies
- repairing holes in walls 🙁
As you can tell from the list above, being an active investor acquires much more hands-on attention vs passive investing.
The IRS states that an active investor are those who materially participate in the management of the real estate business. In this situation, they’re substantially involved in the business’s operations.
Unlike passive investors, active investors can offset losses from real estate investing against their ordinary income.
Good news, right?
If you’re a doctor or other high-income earner, think again.
If you’re an active investor and married making over $150,000 a year, no deduction is allowed. Again, it seems as if we’re being punished for being successful, right?
For those who earn less than $100,000 (single) or $150,000 (married), they can deduct up to $25,000 of losses against their ordinary income from W-2s or 1099s.
But wait, there maybe something you can do about it….
What Is Real Estate Professional Status?
If you’re able to claim real estate professional status (REPS) on your taxes then you can be exempt from both the passive loss rules and the active investor’s income limitations.
This is great news!
In order to qualify for REPS, the good ‘ole IRS states you must meet a few conditions:
(1) must spend the majority of his or her time (more than 50%) in real property businesses in which you materially participate.
(2) the taxpayer must spend 750 hours or more in the real property business and rentals in which he or she materially participates (roughly 15 hours per week).
In layman’s terms: You have to work on real estate more than you do any other job. So being a real estate professional is your primary profession which means you spend more hours in real estate than you do treating patients.
You also must work at least 750 hours on real estate activities with most of this coming from the day-to-day management of your rentals.
Literally anyone can qualify if the criteria above is met. No special license or degree is needed.
How can a doctor qualify?
If you’re a doctor or other high-income professional that typically works more than 40 hours a week, it may not be that easy to cut back in order to claim this status based on your work situation.
But wait…there is another option. Have I ever told you that I love options? 🙂
If your spouse currently doesn’t work, works part-time or is looking for a career change then this could be the key to success.
Basically only one spouse needs to qualify (not both). So if you’re a full-time dentist, then you can continue treating patients (if you want!) and your spouse can fulfill the real estate professional status requirement.
This way, BOTH spouses can benefit from the deductions and possibly HUGE tax savings while not sacrificing any income.
Does This ONLY Work For Real Estate Losses?
The short answer is “yes.” In order to obtain a tax benefit, you have to show losses on any real estate activity you’re in.
If you know anything about psychology then you’re probably familiar with how the brain works when it comes to loss vs gain.
We’re wired to AVOID losses more than we are to try to GAIN something.
For instance, if we have been searching for a particular pair of basketball shoes and Zappos claims that there’s ONLY one pair left….then we’re MORE motivated to buy ’em from FEAR of loss.
Just last night, I told my youngest son that if he doesn’t come to the kitchen and eat then his mom was going to put all of the food away.
He was there in less than 20 seconds :). He didn’t want to lose out!
So now when I tell you that the ONLY way to benefit from using the real estate professional status as a type of tax shelter is to actually show a loss on your real estate then you may initially have a negative reaction.
I get it. NOBODY like to lose. But when it comes to real estate, I’m giving you permission that it’s OK to lose (just this one time)!
That’s what makes real estate investing so great.
Taxes and real estate
One of the key reasons most doctors SHOULD look into real estate investing has to do with the multiple different ways to EXTREMELY lower their taxes.
The MORE you make, the MORE taxes you’ll pay. So you can continue working your tail off putting in longer hours just to make a little more or work SMARTER.
If you play your cards right, you can work less yet make MUCH more.
It all starts with how taxes are calculated when it comes to real estate.
The NOI, or net operating income, is what’s left over after all expenses have been paid. This is what you pay taxes on.
But one of the cool things is something called “phantom expenses” which are expenses you don’t actually pay for. That’s right, you read that correctly.
Not only do you NOT have to pay for them but the IRS will actually allow you to claim them on your taxes.
Sound too good to be true?
Let me introduce you to one of the most powerful phantom expenses around.
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Let’s briefly define what depreciation is. In accounting terms, depreciation is nothing more than the reduction in value of an item over time.
An example of this is the value of the computer I’m currently typing on. What I paid for it a few years ago and what it’s worth now (not much) is much lower. In other words, it’s depreciated in value.
One of the BEST financial gifts we could ever receive (ironically it’s from the IRS) is having the ability to depreciate an appreciating asset.
By doing this, it creates a phantom or paper loss that can be used to offset actual gains which saves you in taxes.
Remember, this isn’t a true expense. You don’t have to worry about taking money out of your pocket to pay for this….
If you claim real estate professional status, losses from depreciation allow you to offset your W2 clinical income and reduce your tax liability.
Is REPS Right For You?
I get it. Being a real estate professional is not for everyone. But if you can swing it, it could be extremely beneficial to your family.
Remember, if you’re married and both of you work, then you’ll first need to figure out who’s going to become the real estate professional.
Your two choices are:
- scale back treating patients or…
- commit to working more hours in real estate than your practice with the minimum number of hours being 750 hours
Consider keeping a detailed log of the hours you’ve spent, but also what exactly you’ve been doing during that time.
- searching for new properties
- marketing to fill vacancies
- responding to tenants, etc.)
If you have further questions, consider hiring a CPA that’s knowledgeable about qualifying for the real estate professional status.