Unlocking Tax Advantages: How to Qualify as a Real Estate Professional

2024-07-16

Reading Time: 3 minutes Qualifying as a Real Estate Professional offers significant federal tax advantages that can significantly benefit those in the real estate industry. By achieving this status, you can offset real property rental losses against other sources of income and exclude real estate gains and revenue from the Net Investment Income Tax. These … Continued

Reading Time: 3 minutes

Qualifying as a Real Estate Professional offers significant federal tax advantages that can significantly benefit those in the real estate industry. By achieving this status, you can offset real property rental losses against other sources of income and exclude real estate gains and revenue from the Net Investment Income Tax. These unique tax exceptions reduce your tax burden and provide the cash flow needed to manage and invest in appreciating real estate assets. However, the path to qualifying is rigorous, involving strict requirements and detailed documentation. This article outlines the essential qualifications, potential pitfalls, and the steps you can take to achieve Real Estate Professional Status, allowing you to leverage these tax benefits.

Real Estate Professionals Must Meet Specific Qualifications

1. Rental activity that qualifies as a real estate professional under 469(c)(7) is not presumed to be passive and will be treated as non-passive if you materially participate in the activity. This key point allows ordinary income in other high tax brackets to be reduced.
2. Here is the tricky part: You qualify as a real estate professional only if:

1. • (1) More than one-half of your personal service hours that you perform in all your trades or businesses during the tax year are in real property trades or businesses in which you materially participate, and
   • (2) Hours spent providing personal services in real property trades or businesses in which you materially participate total more than 750 hours during the tax year.

3. A real estate professional must establish material participation in each rental activity separately. However, the taxpayer may elect to group interests in rental real estate to determine material participation.

If you file a joint return with your spouse, only one of you needs to meet the Real Estate Professional standards to satisfy the rules. Careful planning is essential. For instance, two married dentists were able to sustain the husband’s Real Estate Professional status in tax court. The husband took a part-time role in their joint dental practice (less than 14 hours a week), with documentation supporting this low level of service. The husband spent the rest of his working time as a self-employed real estate broker and managed rental properties.

Be Aware of Pitfalls

• If you work in a real property trade or business (such as real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, rental management, leasing, or brokerage) as a W-2 employee, your hours do not qualify unless you own more than 5% of the enterprise.
• Being a mortgage broker is not a real property trade or business. So, these hours do not count. However, like the dentist example above, qualification is possible by managing where you spend time.
• The excess business loss rules may defer large rental losses should they exceed $578,000 if filing married joint against W-2 or investment income.

Many taxpayers fail to reap the benefits of being a Real Estate Professional due to a lack of evidence and documentation to support their qualifying activities. Contemporaneous daily time reports, logs, or similar documents are not required but are the best evidence in tax disputes. While participation may be established by other reasonable means, the risks of a poor outcome can be much higher. You must also document your time in non-real property activities, as half of your working time must be in real estate. Simply proving 750 hours in real estate activities will not be successful if you are also a full-time surgeon, attorney, or other highly compensated individual.

The ability to offset real estate losses against high tax bracket income in the accumulation years, realize capital gains rates when the appreciated property is sold, or use tax-free exchanges that defer any capital gain taxes are all options that can be used to compound wealth and generate more income.

Your residence state may or may not follow these beneficial federal rules. For example, California does not. In this case, the losses would only be considered passive for California purposes.

We’re here to help

Our real estate team at JLK Rosenberger is happy to discuss how these rules may allow you to maximize your tax benefits. If you have questions about the information outlined above or need assistance with a tax or accounting issue, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.