Real Estate Professional Status

Your ticket to winning the tax game

Last newsletter we talked about cost segregation studies and how to reduce your income tax bill to zero through real estate investing. This week we will take about the requirements you must meet to be eligible to do that. It is true that in order to meet these requirements you must design your life around real estate but the sacrifice and planning it takes will greatly outweigh any of the downsides.

What Is A Real Estate Professional?

A real estate professional is an individual who meets the following three requirements.

1. Over half of the personal services you perform during the tax year were in your real estate business.

2. You worked more than the minimum threshold of 750 hours during the tax year in real property trades or businesses.

3. Material participation in these real estate activities.

Requirements #1 and #2 are simple. More than 50% of the work you do in one year must be real estate related and you must work at least 750 hours. What kind of work counts towards the 750 hours? Development, construction, management, leasing, brokerage, etc. Now that we have that out of the way we can focus on requirement #3(material participation) which is a lot more complex. There are seven ways to pass the material participation test. (seen below) You must qualify for one of them to meet requirement #3.

1. You participated in the 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 the participation of individuals who didn’t own any interest in the activity.

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 individual (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. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.

5. You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 immediately preceding tax years.

6. The activity is a personal service activity in which you materially participated for any three (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 the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Material participation is where most people get caught up or confused. If you meet the 50% and 750-hour requirement you are considered a real estate professional but you MUST also meet the material participation requirement if you want your rental losses to be treated as non-passive and used to offset other taxable income. Many people think just because they are a real estate agent who works full-time 750+ hours a year they qualify for all the tax benefits, but that is not the case. You must materially participate as well. This is a very important distinction to understand.

Why Real Estate Professionals Win

You might be wondering why does the IRS just give me tax benefits if I meet these requirements? Why do I get special treatment because of this? Real estate investing is considered a passive activity but your job for example a regular w2 income is considered active. The passive activity loss rule only allows you to use a passive loss to offset a passive gain meaning you can’t use your real estate depreciation to offset w2 income. However, if you qualify as a real estate professional and materially participate this rule does not apply. Think of it this way, the IRS doesn’t want you making a ton of money, investing it all into real estate, and using it to pay no taxes on your w2 income because real estate is just a side gig for you. They want real estate to be your main gig, if you are going to take advantage of these tax benefits you need to be actively working in real estate pretty much full-time. If you are active in real estate it is no longer seen as a passive activity for you but instead an active one meaning you can use those active losses to offset other active gains.

Why Adding Value Is So Important

I am a big fan of buying distressed properties that I can fix up and add value to before selling them for a profit or keeping them as a rental. Buying properties you can add value to is a great thing to do in general but is especially important when it comes to meeting the requirements of real estate professional status. If you only have one or two properties meeting the real estate professional hourly requirements can be quite tough but it becomes a lot easier when your properties need a significant amount of work. When you fix them up the time you spend working on the rehab of the property can be included in your hours. If you spend 200 hours visiting the job site, calling contractors, or even doing some of the work yourself you just wiped out a massive chunk of the required hours with one property. In reality turning over a couple of properties once a year, creating leases, and doing a little maintenance work is not very time-consuming and will not get you to the hourly minimums.

Spouse Hack

If you are reading this and thinking to yourself “I have a regular w2 job and there is no way I can meet the real estate professional requirements” there might be one way to still qualify. If you can not meet the requirement but your spouse can your w2 taxable income can still be reduced. Let's say there is a married couple and one person makes one million dollars per year and the other only focuses on real estate. While the person with the high income is funding all the deals the other person can be handling all the day-to-day real estate activities and therefore meet the qualification which can be used to offset the one million dollar income. (Note: One spouse must achieve requirements #1 and #2 on their own but both spouses can meet the material participation requirement together.) What if you don’t have a spouse or your spouse also has a w2 income and doesn’t meet the qualifications? There is one last way to reduce your income without having to meet the real estate professional qualifications. Investing in short-term rentals and renting them out for 7 days or less makes you eligible for what’s called the “short-term rental loophole” We will discuss this loophole in the next newsletter.

Conclusion

If you ever find yourself wondering if you are taking full advantage of real estate and the tax benefits it provides remember the three requirements it takes to meet real estate professional status. If you are meeting all three requirements you are putting yourself in a position to take full advantage.

And there you go! That is how you reduce your tax bill to zero and keep every dollar you make in your pocket. While it's complicated it's also very simple. Make a living working in real estate, take the time to master it, and it will provide you with all the financial benefits you could ask for. (Note: this is part 2 of how to pay $0 in taxes, if you missed the first newsletter go back and read that post and it will make more sense)