Do you own rental properties, fix-n-flip homes, invest in property, or even improve and redevelop real estate? If a significant amount of your time and energy goes into real estate in exchange for some level of income, there’s a crucial tax strategy you don’t want to miss: qualifying as a real estate professional.
Even if you’re not putting For Sale signs in front yards and hosting open houses every weekend, you may be able to qualify as a real estate professional in the IRS’ eyes. That will allow you to achieve a significant tax advantage: deducting passive losses.
In fact, the IRS considers almost a dozen classifications of real estate business activities: acquisition, brokerage, construction, conversion, leasing, management, operation, redevelopment, real property development, reconstruction, and rental operation.
Just how important is this real estate professional qualification?
Once you qualify as a real estate professional, you’ll be able to deduct passive losses and circumvent the Net Investment Income Tax.
For instance, if you have a rental property that produced a $10,000 loss (on paper) last year, you may not be able to utilize that loss when it comes tax time because you earn more than $150,000. But if you can qualify as a real estate professional, that $10,000 passive loss can be deducted from ordinary income when it’s time to file your taxes.
While the benefits and savings are clear, the process of qualifying as a real estate professional must follow stringent guidelines.
According to the IRS Sec. 469(c)(7)(B), an individual must meet the standard of two quantitative tests to qualify:
1. The taxpayer performs more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates,
2. More than one-half of the personal services performed in trades or businesses by the taxpayer during the tax year are performed in real property trades or businesses in which the taxpayer materially participates.
However, that still won’t allow you to deduct passive losses, as you must pass the test for material participation.
There are actually seven separate tests to ensure you’re involved “in the operations of the activity on a regular, continuous, and substantial basis.”
These are the tests for material participation:
1. Each tax year, you must participate in the activity for more than 500 hours.
2. Your participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
3. Each tax year, you participate in the activity for more than 100 hours, but your participation cannot be less than the participation of any other individual in the business.
4. Your activity is a significant participation activity for the tax year, and your aggregate participation in all significant participation activities during the year exceeds 500 hours.
5. You materially participated in the activity for at least five of the last 10 tax years, although they don’t need to be consecutive years.
6. Your activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether consecutive or not) preceding the tax year.
7. Based on all the facts and circumstance, you participate in the activity on a “regular, continuous, and substantial basis” during the tax year.
As if those seven tests weren’t enough, I have a few additional notes on the material participation standard:
• If you’re an employee of the company, your hours aren’t counted unless you are at least a 5% owner.
• Some tasks like education, reviewing financial statements, locating new properties, researching deals, etc. do not count towards your material participation hours.
• If you own multiple rental properties/investments, you must qualify separately for each, which is difficult. However, we may be able to get around that by establishing a grouping election per IRS Regs. Sec. 1.469-9(g) in some specific cases.
• If you hold an interest in a business or property through a limited partnership, you may only pass the material participation test using #1, 5, 6, or 7 from the previous list.
• If you’re married and your spouse participates in your investments, you must count the hours that he or she is involved, even if they don’t have an ownership interest in the business or if you don’t file a joint tax return. But it’s important to mention that your spouse’s hours will only count towards the test for material participation, not your real estate professional designation.
Obviously, there’s a lot of fine print that we need to get correct from an IRS standpoint, but the result in passive income deductions will be well worth it!
For more information or to schedule a tax consultation with my office, click here to get started.