How To Benefit From Real Estate Professional Tax Status

real estate professional tax status

For high-income earners, real estate professional tax status is one of the most powerful tax tools available. But it does take some work in order to qualify.

Unfortunately, most doctors and other professionals have VERY few tax advantages due to two main issues:

  • employment status
  • their HIGH income

Employment status

Let’s start with employment status. Most doctors complete training and go to work for either hospitals or groups. This is due to the fact that’s it costs an arm and a leg to either buy a practice or start one from scratch especially when in tremendous student loan debt. 

Because of their employment structure, they’re paid mainly as a W2 earner or 1099 status. Unfortunately this results in very few tax losses versus someone that chooses the self-employed route which allows them to deduct expenses through their respective business or practice.

High income status

Another issue keeping high-income earners from most tax advantages has to do with them being….successful. That’s right, we’re punished for making a good income which usually is acquired from sacrificing our time, energy and money.

Also, don’t forget about the hundreds of thousands of dollars in students loans most take out just so we can obtain our coveted degree.  🙁

And because of our high income status, many of the tax deductions are phased out above a certain income level.

Have you ever given your CPA medical expense or student loan records you’ve paid only to be told that you can’t claim them due to your income level? Sucks doesn’t it?

Don’t get too upset because there are several ways you can lower your taxes as long as you have a good CPA on your team.

[Disclaimer: I’m not an accountant, lawyer or financial advisor, so please consult your own team of professionals about the topics covered in this article.]

One of the biggest kept secrets that can significantly reduce your tax burden is something called Real Estate Professional Status (REPS).

If you’ve never heard of this then after reading this article, you’ll understand how you can use it to your advantage to save on your tax bill each year.


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What Is Real Estate Professional Status?

Real estate professional status (aka REP status or REPs) is a designation given by the IRS to a person that qualifies to claim that they work on real estate properties and related real estate work the majority of the time.

As you can imagine, there are certain requirements in order to claim the status which I’ll go into more detail shortly. 

Before we discuss the qualification requirements, let’s take a look at how these rules started in the first place…

History of the Real Estate Professional Rules

Internal Revenue Code Section 469 (passive activity loss rules and credits limited) states that losses from a “passive activity” may only be used to offset income from a passive activity.

Passive activity losses are only deductible against passive activity income. A passive activity is one involving a trade or business in which the taxpayer does not materially participate.

Rental real estate activities are generally considered passive activities regardless of whether the taxpayer materially participates. Thus, the passive losses from such activities are usually only deductible against passive activity income.

{As a side note, many times people think investing in a real estate syndication will offset their active income. Which, according to the rules, is does not.}

Under Internal Revenue Service Code Sec. 469(c)(7), any taxpayer that meets the qualification of a real estate professional then overcomes the presumption that all rental activities are passive (good news for the high-income earner wanting options to lower their business/practice income). 

In 1993, Congress recognized the issues treating all rental activities as passive and sought to provide an exception to a narrow category of taxpayers…the real estate professionals.

Because of this, Congress added Sec. 469(c)(7). This stated that a taxpayer who qualifies as a real estate professional overcomes the presumption that all rental activities are passive as long as they establish that they materially participate in a rental real estate activity.

By doing this, then the activity will be considered nonpassive.

How Do You Qualify For Real Estate Professional Tax Status?

In order to qualify for REPS, the IRS requirements 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 (750-hour requirement) or more in the real property business and real estate rentals in which he or she materially participates (roughly 15 hours per week).

Some of the activities the IRS states meet the professional status requirements include:

  • Real property development or redevelopment
  • Property acquisition
  • Rental management
  • Construction
  • Brokerage trade or business
  • Operations

To discuss this a bit further, materially participating means the person is actively involved in operations of the activity on a basis that is:

  • regular
  • continuous
  • substantial

Whenever I invest in real estate syndications, I’m investing as a limited partner (LP) in a LLC which holds the property. Typically, no interest in a limited partnership as a LP is treated as an interest with respect to which a taxpayer materially participates.

Materially participating in an activity (7 tests)

There are 7 material participation tests and you only need to meet one of them:

#1. You participated in the real estate activity for more than 500 hours.

#2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including individuals who are not owners of interests in the activity for such year.

#3. You participated in the activity for more than 100 hours during the tax year, and
you participated at least as much as any other single person (including individuals who
didn’t own any interest in the activity) for the year.

#4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours

#5. You materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year.

#6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

#7. Based on all of the facts and circumstances, you individual participated in the activity on a regular, continuous, and substantial basis during such year.

What Are The Benefits Of Being a Real Estate Professional?

One of the main reasons I started investing in real estate was to begin replacing my ordinary income (dental)  with passive income

The more I learned about real estate investments, the more excited I became regarding other benefits such as having tenants pay for the property and numerous tax benefits (depreciation).

As a side note, I took a deep dive into how depreciation can help the high-income earner along with a cost segregation study example in this video:

Depreciation in real estate

Just when I thought investing in real estate couldn’t get any better, I found out about more perks available to those who qualify as real estate professionals.

This specific designation allows investors to deduct business expenses, rental losses, and rental property depreciation from their overall taxable income. Reread that last sentence again and think about the power this could have against your active income. 

On the flip side, a person who doesn’t qualify for REPs status would only be able to use losses as a way to offset rental income or capital gains.

Now this isn’t exactly a bad thing as I found out once I started investing in syndications. The depreciation received each year that’s reflected on the K1 tax form allows the passive income created annually to be tax-free.

Try to get that in the stock market.

REPs example

Here’s an example to help explain further:

Dr. S invests $100,000 in a syndication in North Carolina. The general partners of the project were able to take advantage of bonus depreciation thus accelerating losses the first year.

On his K1 tax  form, he was able to capture a $30,000 loss. During that year, his dental income was $230,000. If he filed as a real estate professional, the $30,000 could be deducted from his $230,000 income.

This would lower his overall taxable income to $200,000 for the tax year. If he didn’t meet the real estate professional requirement, the losses could only be used to decrease the passive income paid out quarterly from the project (again, getting tax-free income ain’t bad!).

Summary

One of the top advantages to real estate investing is the numerous tax benefits available. Because of this, it’s very important to understand how to use them to your advantage.

Investors are able to benefit by using depreciation and losses to their advantage by becoming a real estate professional. 

If you want more information about becoming a real estate professional, consult with a qualified tax professional then you’ll be well on your way to a MUCH lower tax bill.

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