Are you looking to maximize the tax benefits of real estate investing? Being classified as a real estate professional by the IRS can provide you with significant advantages. However, meeting the criteria for this designation is essential. In this article, we will explore who qualifies as a real estate professional and how this classification can benefit you during tax season.
Real Estate Professional Tax Benefits
Real estate ownership already offers several tax benefits, but there are even more perks available to those who qualify as real estate professionals. This designation allows qualifying investors to deduct business expenses, losses, and property depreciation from their overall taxable income. On the other hand, investors who do not meet the criteria can only use losses to offset rental income or capital gains.
Let's consider an example. Suppose you had $25,000 in losses due to property vacancies and an additional $15,000 in depreciation across your rental portfolio. If you were classified as a real estate professional and made $170,000 in annual income, you could deduct the combined $40,000 from your total income. This would lower your taxable income to $130,000 for the tax year. Without the real estate professional classification, these losses could only be used to decrease your rental income. As you can see, meeting the requirements can make a significant difference in your tax liability.
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Real Estate Professional Rules
To be classified as a real estate professional for tax purposes, you must meet certain criteria outlined in IRS Publication 925. Let's take a look at these rules:
More Than 50% Rule
According to the IRS, more than half of your services performed in a tax year must be related to "real estate property trades or businesses." This means that more than 50% of your working hours should be dedicated to real estate. If you have a full-time job outside of the real estate industry, you may not qualify as a real estate professional. For example, if you work 40 hours a week at Google and spend 5 to 10 hours per week managing a rental property, you would not meet the real estate professional requirements.
750 Hour Requirement
To qualify as a real estate professional, you must spend more than 750 hours per year performing services related to real estate trades or businesses. This requirement is calculated annually, and there are no limitations on when the hours are worked, as long as they fall within the tax year. The activities that count towards this requirement include rental unit management, new construction, property and business operations, time spent as a real estate agent or broker, property development or redevelopment, and property acquisition. It's important to document and prove these hours to the IRS.
Single Taxpayer Requirement
Each person seeking real estate professional tax benefits must individually meet the 50% rule and 750-hour requirement annually. Hours cannot be combined with a business partner to qualify for the designation. However, there is an exception for married couples filing jointly. If you or your spouse meet the requirements, the benefits of being a real estate professional would apply to your combined income, even if one spouse earns their primary income outside of real estate.
Material Participation
The IRS uses the material participation test to determine if your working hours can count towards the real estate professional designation. You must meet at least one out of seven material participation criteria. One common example is participating in the real estate activity for at least 500 hours. It's crucial to identify all the businesses or real property trades in which you materially participate.
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How To Document Real Estate Professional Status To The IRS
To receive real estate professional tax status, you must provide supporting documentation to the IRS. This can be done using various methods such as Excel workbooks, Google sheets, or time-tracking websites. The IRS does not have specific requirements for submitting these hours, but consistency throughout the tax year is important. It's recommended to maintain a system throughout the year instead of putting it together all at once. When documenting your hours, include the time and date, activities performed, duration of work time, and the address of your work or related property.
How To Document "Unprovable Time"
Counting all your working hours over a year may seem challenging, especially when unexpected situations arise. These situations, where there is no supporting evidence, are referred to as "unprovable time." When documenting unprovable time, avoid exaggerating or stretching your hours just to meet the requirements. Be reasonable and imagine explaining your unprovable time directly to an auditor. Trustworthiness is crucial in maintaining your credibility as a real estate professional.
Will Passive Investments Help You Qualify?
Passive investments generally do not help you qualify as a real estate professional. The IRS has strict criteria, and active involvement in real estate is a key factor. Passive income investors who only spend a few hours a week or month checking in with property managers typically do not meet the IRS standards. However, if your "passive investments" require substantial time and work on your part, consider documenting your involvement. This information can help you determine if you qualify and understand the level of your active participation.
Summary
Tax benefits are one of the most attractive perks of real estate investing, and being a real estate professional allows you to fully utilize these advantages. Remember, proper documentation is necessary to meet the IRS requirements. Work with a qualified tax professional to navigate the qualifications and enjoy the benefits of real estate investing.
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