Real estate is a popular asset class among physicians. Many pursue passive real estate investments, which include real estate syndications and real estate investment trusts (REITs). But some investors like to be hands-on, choosing their properties and managing renovations themselves.
If you and your spouse are active real estate investors but your household earns more than $150,000 per year, however, your real estate losses may be limited.
That’s where real estate professional (“REP”) status comes in. Claiming this designation on your taxes can allow you to continue to offset losses against your income without being subject to an income limitation.
Passive Real Estate Investing
A passive investor is someone who does not “materially participate” in the buying, selling, or management of properties. That means as the investor, you may passively invest in a property through a fund manager or sponsor who handles the day-to-day operation of the property or investment portfolio; investors are hands-off. Real estate syndications, in which investors pool their funds to purchase an identified investment property, are popular passive real estate investments. Real estate funds and REITs are passive investments, too.
But passive investors also include those who do not spend enough hours in a year in real estate activities for real estate to qualify their primary profession.
Passive investors are subject to passive activity loss rules. This means if your real estate investments generate losses, you cannot offset those losses against your ordinary income. (For more about the tax implications of real estate syndication deals, read this.)
For example, say you’ve invested in a syndication deal that purchased an investment property requiring extensive renovations. After deductions and depreciation, the rental generated a loss of $10,000 this year.
You cannot offset that $10,000 against your W-2 or business income. However, you can offset that loss against any passive gains you have in the current tax year, such as gains from other syndications or real estate. The losses are not gone but rather deferred — you can accumulate the losses over the life of the investment and take them all in the year you sell the property.
Active Real Estate Investing
Active real estate investing is probably what you imagine when you think of real estate investing: Purchasing a property yourself to operate as a rental or to flip and sell for a profit. In active investments, investors are responsible for finding investment properties, procuring financing, and managing the property, either personally or by hiring a property management firm. Active investing is much more hands-on than passive investing and requires much more detailed knowledge of real estate as an asset class as well as time.
From the IRS’s perspective, active investors are those who materially participate in the management of the real estate business — that is, they are continually and substantially involved in the business’s operations. To be considered an active investor, you must own at least 10% of the rental property in question and participate in management decisions “in a significant way.”
This distinction is important because active investors can offset losses from real estate investing against their ordinary income, unlike passive investors.
Active real estate investors who earn less than $100,000 as individuals or $150,000 as married couples can deduct up to $25,000 of losses against their ordinary income from W-2s or 1099s. As you approach those income limits, the deduction decreases, and above them, no deduction is allowed.
What is Real Estate Professional Status?
If you can claim on your taxes that you are a real estate professional, however, you can be exempt from both the passive loss rules and the active investor’s income limitations.
To claim REP status, you must be able to check several boxes:
- You materially participate in more than 750 hours of service during the year in real property trades or business management. (For context, that’s about 15 hours per week.)
- More than 50% of the services you perform in a trade or business are done in real property trades or businesses in which you materially participate. This means that you must spend more of your professional time on real estate than on anything else.
- You must materially participate in your investments. That doesn’t necessarily mean acting as the property manager — by the IRS’s definition, you must be personally involved in “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” You can continue investing in syndications or other passive investment vehicles, but that time does not count toward your 750 hours for REP status.
You do not need a license or certification to claim REP status — it’s entirely based on the work you did during the tax year. The tax code and legislation surrounding REP status are not particularly clear, which has resulted in a lot of litigation on these issues. If you pursue REP status, keep a detailed record of the time you spend on your real estate business so that you can verify it in case of an audit.
How to Determine Your REP Status
If you already have real estate businesses, you may be closer than you think to claiming REP status.
Start by making a list of all of your real estate businesses and investments. Highlight those that you materially participate in — remember that private equity investments and REITs don’t count.
Calculate the total number of hours you and your spouse spend on each of those businesses. If you are an employee of any of those businesses, you cannot count those hours unless you own 5% or more of the company. Then, turn to each of the tests the IRS uses for REP status:
- For the 50% test: Did you spend more than half of your working time on your real estate business? To determine this, you must include the hours your spouse spent on real estate. (This means that if only one partner is working on the real estate business, that person must work as much or more as the other partner.)
- For the 750-hour test: Did you work more than 750 hours? You only need to count your or your spouse’s hours, not both.
If the answer to both questions is yes, you may be able to qualify as a real estate professional.
But before you get ahead of yourself, there’s one more step. The IRS allows taxpayers to aggregate all of their rental property activities to determine material participation. If you materially participate, then all of your rental activities are considered non-passive; if you do not, then they are all considered passive. This is a formal election that your CPA will make on your tax return. And once this election is made, you cannot change it unless there is a material change in your situation.
Talk to your financial advisor and/or your CPA about whether pursuing real estate professional status is right for you, your spouse and your business. REP status can allow you to offset losses from your rental properties, making the transition into real estate investing easier. But REP status does not give you access to any additional education or expertise — and there are some important pitfalls to understand before you commit to this designation.
Challenges of Real Estate Professional Status
The IRS looks closely at taxpayers who claim REP status. Remember that the 50% test limits REP status to people who work primarily in real estate; trying to qualify as an REP while keeping a full-time job will raise red flags.
Track your hours and activities in case you are ever audited. The more detailed and meticulous, the better. Consider using a separate email address for your real estate business so you can easily find records of correspondence. Time-tracker apps designed for freelancers can help you manage your time too.
If you’re involved in multiple real estate-related businesses, like selling or renovating homes or managing rental properties, you can combine these businesses together under the umbrella of real estate activities. This can make it easier to qualify for REP status.
As always, seek advice from qualified professionals — including your financial advisor, CPA, and potentially an attorney — to explore whether REP status is right for you. If you do not yet meet the necessary standards, they can help you chart a course to make your business more robust. And if you do, they can help you get organized so compliance never becomes a challenge.