You can be a lawyer, accountant, or medical doctor and also qualify as a real estate professional with respect to your rental properties.
The classification as a real estate professional improves your after-tax rental property profits by allowing passive loss tax deductions that require your partner (the government) to chip in with tax money.
With good planning, you can get your IRS partner to chip in its cash sooner rather than later. Sooner builds your profits quicker and to a higher level (because you have more cash to invest earlier).
Real estate professionals who meet the material participation standards may deduct their rental property passive losses immediately, regardless of their incomes. Non–real estate professionals with joint incomes over $150,000 may not deduct their losses until later—perhaps, not until they sell the property.
Thus, to maximize your real estate profits, you may want to qualify—or, if married, want your spouse to qualify—as a real estate professional.
Qualifying as a Real Estate Professional
Either you or your spouse will qualify as a real estate professional for the year if you or your spouse spends
Example. You work 925 personal service hours a year on your rental properties and 921 hours (excluding vacations, holiday, and sick days) on your W-2 job as the owner-employee of your S corporation. You pass the 750-hour test and you pass the more-than-half-your-work-time test (1,846 total personal service hours divided by 2 equals 923 hours—you worked 925 hours on the real estate). Thus, you are a real estate professional for the year, and you may deduct your rental property losses on the properties in which you materially participate.
Planning note. Investor time counts for the 750-hour test but not for the more-than-half-your-personal-services work-time test.
One spouse must single-handedly satisfy the time-spent rules for real estate professional classification. When one spouse passes the time tests, both spouses are deemed to pass. Thus, if the wife qualifies by herself as a real estate professional, tax law deems the husband a qualified real estate professional, too.
Proof of Time Spent
You need proof of time spent. In its audit guide on rental properties, the IRS lists the following two techniques for IRS examiners to follow:
The IRS tells its examiners that your “reasonable records” of time spent may include:
Keep in mind that the burden of proof is on you, the taxpayer. Thus you need proof of time spent. For more on how to keep your proof and why this is critical to your passive loss deductions, see FAQ titled “How to Audit-Proof Your Time Spent on Rental Properties.”
Real Property Trades or Businesses
Time spent on your rental property is time spent on your real property trade or business. Remember, either you or your spouse must pass the time test for real property trades or businesses in order to qualify for tax-favored real estate professional status.
The term “real property trade or business” means any real property
Employee alert. Personal services performed as an employee do not count as work performed in real property trades or businesses unless such employee is a 5-percent-or-more owner.7 You are a 5-percent-or-more owner if you own (or are considered to own) more than 5 percent of your employer’s outstanding stock, outstanding voting stock, or capital or profits interest.
Real estate agent. Brokerage includes activities by a real estate agent—see FAQ titled “Are Real Estate Agents and Real Estate Brokers One in the Same for Passive Loss Rules?”
Your legal share of government subsidies for your rental properties depends on either your
To learn how to materially participate, see the article titled “How to Materially Participate to Deduct Rental Property Tax Losses.”
Information sourced from the Bradford Tax Institute.