Are you a real estate investor looking to maximize your tax benefits? Understanding the real estate professional status designation can make a significant difference in claiming expenses on your taxes. In this article, we'll guide you through everything you need to know about this designation and how it can work to your advantage.
What is the Real Estate Professional Status?
The real estate professional status designation means that you operate a real estate business and actively work in it on a regular basis. To qualify for this designation, you need to meet specific criteria set by the IRS:
- More than half of the personal services you performed in all trades or businesses during the tax year were in real property trades or businesses you materially participated in.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
This designation has meaningful implications for real estate investors operating a real estate business. However, there may be some uncertainty and questions surrounding this status. Let's delve into the definition, rules, tax deductions, and best practices associated with the real estate professional status.
Understanding the Real Estate Professional Definition
If you're a property manager or real estate investor who actively works in your real estate business, you likely qualify as a real estate professional according to the IRS. To obtain this designation, you need to spend more time in real estate than in any other job. This can be advantageous for married couples or common-law partners, as we'll explain later.
To qualify, you must spend 50% or more of your personal services in the real estate business. While you can have a part-time job, you need to be able to prove, in case of an audit, that over 50% of your time was devoted to materially contributing to your real estate business.
What Qualifies as a "Real Property Trade or Business"?
The rules governing what qualifies as a real estate business activity can be somewhat vague. According to section 469(c)(7)(C) of the IRS code, a "real property trade or business" encompasses various activities, such as development, construction, rental, operation, management, leasing, and brokerage.
Property management businesses fall into the "management" category mentioned above. This means that as a property manager, your participation in real property trade or business hours will count toward the 750-hour test and the "more time in real estate than anywhere else" test.
However, not all hours will count toward these tests. Educational and research hours typically do not count, nor does infrequent travel time. It's essential to keep track of your time using a spreadsheet, calendar, or time tracking app, as the burden of proof in the event of a tax audit falls on you, the real estate investor.
Maximizing Tax Benefits: Real Estate Professional Tax Deductions
Qualifying as a real estate professional can result in significant tax benefits. When you qualify as a real estate professional and materially participate in your own rental activities, your rentals are considered "non-passive."
The advantage of non-passive rental losses is that they can offset any type of income, without limitation. Normally, rental losses are passive and can only offset passive income. However, when you meet the criteria for real estate professional status and materially participate in your rentals, your rental losses become non-passive.
For example, if you have a net income of $150,000 from managing your properties and $20,000 in passive losses, these losses can offset your income. This can potentially save you thousands of dollars in taxes. Property managers and those who manage their own properties have an advantage in qualifying as a real estate professional because they can log hours towards the 750-hour test and are typically deemed to be materially participating.
Best Practices for Real Estate Professional Designation
To make the most of the real estate professional designation, consider the following best practices:
- Marriage or Common Law: If you have a spouse, obtaining the designation becomes easier. Only one person in the couple needs to qualify, allowing both partners to claim associated real estate deductions. For single individuals, they must fulfill all the criteria on their own or work a full-time job.
- Material Participation: Material participation means actively being involved in the day-to-day management, operations, and aspects of your real estate business. Property management software can help demonstrate your active involvement.
- Passive Investor: Merely being a passive investor or participating in crowdfunding does not qualify for the real estate professional designation. To qualify, you must materially participate in the day-to-day operations of the real estate business itself.
- LLCs: While Limited Liability Companies (LLCs) offer liability and asset protection, they do not affect your status or qualification as a real estate professional. Whether your properties are held in an LLC or not, the requirement of material contribution to management and operations remains the same.
- Year-by-year: The real estate professional designation must be proven every year. Obtaining it in one year does not guarantee it in subsequent years.
How to Benefit from the Real Estate Professional Status
If you have a full-time job, it may be challenging to qualify for the real estate professional status. You need to demonstrate material participation by spending 750 hours or more and dedicating more than half of your time to real estate-related activities.
Real estate investors can still benefit from local management support but must be able to prove material contribution. Additionally, owning 5% or more of a real estate business allows you to qualify as a real estate professional if you materially participate in the listed categories, logging your hours and tasks meticulously:
- Real property development
- Redevelopment
- Construction
- Reconstruction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage trade or business
Technology has made obtaining the real estate professional status easier by enabling self-management. Platforms like Hemlane provide innovative software, access to leasing agents, and a 24/7 repair center, allowing real estate investors to remotely manage their properties and achieve the professional status.
In conclusion, understanding and obtaining the real estate professional status can bring substantial tax benefits for real estate investors. By meeting the criteria and following best practices, you can unlock the full potential of this designation and make the most of your real estate business.
