There are many tax advantages involved in real estate ownership, however, there are additional perks available to those who qualify as real estate professionals. Although it may seem daunting to take the extra steps to achieve real estate professional status (REPS), qualifying owners will enjoy the added benefits of reducing taxable income by writing off significant losses including depreciation from real estate activities. Real estate owners will want to become familiar with the requirements involved and make sure they qualify.
Who is Considered a Real Estate Professional and Why Does it Matter?
Rental real estate losses are usually considered passive activities and are subject to passive activity loss limitation rules. However, a taxpayer who qualifies as a real estate professional and materially participates in his or her real estate rentals may avoid these passive loss limitations and is able to deduct rental real estate losses against other income sources (commissions, wages, etc.) under IRC Section 469(c)(7). Qualifying creates significant advantages and the potential for tax-free cash flow during the ownership period.
What are the requirements to qualify as a real estate professional?
The most important consideration to qualify as a real estate professional is how the professional spends his or her time. Those seeking to become real estate professionals must:
- Own rental real estate
- Spend more than 50% of their personal services time during the tax year on activities in real property trades or businesses in which the professional materially participates, and
- Perform more than 750 hours of service in the same real estate trades or businesses, devoting more than one-half of personal services working hours to their real estate business. Hours spent as an employee are not counted unless the employee is also a greater than 5% real estate company owner.
Participants in the real property trades or businesses include:
- Real estate developers, builders, and contractors,
- Owners of rental properties,
- Property managers, leasing and acquisitions
- Participants in the Real Estate Brokerage business – provided they meet the 50% participation and 750-hour requirements.
Note: Real Estate Appraisers and Mortgage Loan Brokers are excluded
Material Participation in real estate rentals includes:
- Managing and operating the rental real estate activity for more than 500 hours per year; or
- Performing substantially all the work required to manage and operate the rental real estate during the year, or
- Working more than 100 hours during the year, with no one participating more than the taxpayer
- The individual 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
Note: Activity of one spouse can be attributed to the other spouse and activity from multiple properties can be combined through use of the proper elections (see aggregation rules below)
Note: Work done as an investor does not qualify (reviewing financial reports and monitoring finances)
Avoiding Possible Pitfalls
Most taxpayers with just a few rental properties will find it difficult to achieve real estate professional status, especially if the taxpayer is also receiving a W-2 from a full-time job. Regardless, the IRS and courts have made it clear that detailed service records must be maintained and credible. Recent tax court rulings in favor of the IRS highlight the importance of properly maintaining records of time spent conducting real estate activities. Additionally, these time records must accurately count only time spent performing real property services, rather than “ballpark guestimates” that could include time spent traveling and meal breaks.
Aggregation of Rental Real Estate
Each rental property is a separate activity, making it nearly impossible to meet the 750 hours required for each, unless the taxpayer elects to combine. A taxpayer may elect to combine all interests in real estate, including real estate held through passthrough entities, as one activity. This may allow the taxpayer to meet the material participation tests when examined cumulatively. The election to treat all interests in rental real estate as a single activity is binding for all future years unless there is a material change in facts and circumstances. Taxpayers who fail to formally elect to aggregate properties may make a late election, attaching a statement to their tax return indicating that the taxpayer wishes to aggregate the properties. This can only be done if the affected tax returns were filed as if the election had been made.
Five factors for grouping activities are similarities and differences in types of business, the extent of common control and common ownership, geographical location, and interdependency between activities – buy or sell amongst themselves, have the same customers, have the same employees, single set of books and records
How Can We Help?
There are many considerations when pursuing real estate professional status. For assistance or questions, please contact a member of Cherry Bekaert’s Real Estate Tax practice.
