By Dr. James M. Dahle, WCI Founder
If you're involved in direct real estate investing, you may have heard about the benefits of qualifying yourself or your spouse as a real estate professional. By achieving Real Estate Professional Status (REPS), you can use depreciation losses from your real estate investments against your professional income, potentially reducing your taxes dramatically, even down to zero. However, claiming REPS is not as simple as it seems. Inappropriate claims can lead to audited and costly consequences. It's crucial to have a strong understanding of the rules surrounding REPS.
Requirements to be Eligible for Real Estate Professional Status (REPS)
There are three main requirements to claim REPS:
#1 750-Hour Rule
You must spend at least 750 hours on "real property trades or businesses" during the year. This includes activities such as development, construction, rental, management, and more. However, it's important to note that activities like education, property searching, and studying financial statements do not count towards these hours. The IRS requires work activities, not investment activities, to meet this requirement. Additionally, if you are an employee, your hours only count if you are a 5%+ owner of the business or property.
#2 Greater Than Half of Professional Time Rule
To qualify for REPS, real estate cannot be your side gig. It must be your main focus. You need to spend at least 750 hours on real estate activities and not more time on other professional endeavors. This requirement can make it challenging to qualify for REPS, as it limits your earning potential by capping the amount of time you can spend on real estate. However, many married couples specialize, allowing one partner to focus on real estate while the other maintains their primary profession.
#3 Material Participation
You must materially participate in each real estate "activity" or property where you plan to use depreciation losses against your active income. This means actively managing and participating in the property's operations, such as maintenance, renovations, leasing, and more. Hiring a property manager for some properties may disqualify those properties from counting towards REPS unless you properly combine them using a "grouping election." Your spouse's time does not count towards the 750-hour requirement but can contribute to meeting the material participation requirement.
While meeting these requirements may seem challenging, it is essential to avoid penalties and maximize the benefits of REPS. Keep records of your time and activities performed to be prepared for potential audits.
How Many Properties Do You Need to Qualify for Real Estate Professional Status?
To claim REPS, meeting the 750-hour requirement is crucial. Even if you efficiently manage your properties in just 10 or 20 hours each year, you still need to meet the 750-hour requirement. This means that with 15 hours spent on each property, you would need at least 50 properties to qualify. If you spend 100 hours per property, you would need at least eight properties to qualify. Meeting these requirements without personally doing a significant amount of rehab work on the properties may be challenging. It is worth considering if the benefits outweigh the effort required.
Real Estate Professional Tax Deduction
If you qualify for REPS, you can benefit from tax deductions. Without REPS, most individuals can only deduct up to $25,000 in passive losses against their ordinary income, with phase-outs between an income of $100,000-$150,000. However, with REPS, you can subtract depreciation from your clinical income, potentially reducing your taxes to zero. It's important to note that depreciation is recaptured when selling the property.
Additionally, income from real estate activities eligible for REPS is exempt from Net Investment Income Tax (3.8% on investment income over $200,000 or $250,000 for married couples filing jointly).
Short-Term Rental Loophole
For those interested in short-term rentals like Airbnb and Vrbo, there is a way to bypass the 750-hour requirement. Short-term rentals are considered more like running a hotel and are exempt from the rental activity presumption. However, to qualify, you must keep stays to less than seven days on average, avoid providing substantial services, and manage the property yourself. By utilizing this loophole, you can write off bonus depreciation against your ordinary income. Keep in mind that providing substantial services may subject your income to payroll taxes.
Image: Your Guide to Short-Term Rentals
Do Passive Investments Qualify for Real Estate Professional Status?
For those who invest indirectly in real estate through syndications, private funds, or REITs, the same requirements apply for REPS. You need to achieve REPS status and materially participate in each activity or investment to use the associated depreciation benefits. Limited partners in these investments are generally considered not to have materially participated. However, specific circumstances outlined by the IRS may still allow limited partners to qualify. It's essential to evaluate your level of participation and ownership structure to determine if you can claim the benefits of REPS.
Whether you engage in long-term rentals, short-term rentals, or syndications, it is vital to view these properties as more than just investments to qualify for REPS. By treating real estate as your primary job or a significant second job, you may be eligible for these valuable tax breaks. Remember to keep thorough records of your time and activities performed as evidence in case of an audit.