Unlock Significant Tax Savings: How Qualifying as a Real Estate Professional Can Lower Your Tax Burden

Qualifying as a real estate professional offers substantial tax benefits, such as deducting losses against nonpassive income and avoiding the net investment income tax. However, this status alone does not automatically classify rental real estate activities as nonpassive; rather, it enables the taxpayer to challenge the assumption that all rental activities are passive.

For tax purposes, passive income activities include trade or business activities where the taxpayer does not materially participate during the year or rental activities, regardless of the level of participation, unless the taxpayer qualifies as a real estate professional.

Passive activity losses are typically limited to offsetting passive income, with any excess carried forward. However, taxpayers qualifying as real estate professionals can bypass this restriction, allowing the losses to be used without limitation. There are basis and at-risk issues also to be considered. To achieve this, the taxpayer must demonstrate material participation in each rental activity or, if they choose, in the aggregated rental activities.

Qualification Criteria

To qualify as a real estate professional, taxpayers must spend more than half their working time in real estate businesses and complete at least 750 work hours in real property trades or businesses where the taxpayer materially participates.

For joint filers, a spouse’s participation can contribute to meeting the material participation requirement, but their services cannot be counted toward qualifying as a real estate professional.

Personal services performed as an employee do not contribute toward qualification unless the individual owns at least 5% of the business. Activities such as studying and reviewing financial statements, searching for new properties, attending educational courses, preparing financial summaries, or managing finances in a nonmanagerial role also do not count toward the required material participation hours.

A closely held corporation can qualify as a real estate professional if more than 50% of its gross receipts are derived from real estate activities in which it materially participates. To meet these qualifications, a real estate business must engage in one or more of the following activities: acquiring properties, brokering transactions, constructing or reconstructing properties, converting properties, developing or redeveloping properties, operating or managing properties, or renting and leasing properties.

Material Participation

The IRS uses material participation tests to assess whether taxpayers have been actively involved in a business or investment activity. These tests determine a taxpayer’s eligibility for certain tax deductions or credits related to that activity. To qualify, taxpayers must satisfy one of the following IRS tests:

1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual’s participation in the activity for the tax year constitutes substantially all the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year.
3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year.
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours.
5. The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years immediately preceding the tax year.
6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.
7. Based on all the facts and circumstances, the individual participates in the activity regularly, continuously, and substantially during the year. Other rules apply.

Note it is critical to maintain contemporaneous records to support material participation. The courts have been extremely rigid in this regard.

A real estate professional typically must establish material participation for each rental activity separately but may choose to aggregate all rental interests to determine material participation.

In conclusion, qualifying as a real estate professional provides substantial tax benefits, particularly for those with rental income. By meeting the IRS’s material participation criteria, taxpayers can deduct losses without limitation and avoid the 3.8% net investment income tax. This designation is valuable for reducing tax liabilities and can lead to considerable tax savings, making it an important strategy for anyone involved in real estate activities. Contact your tax manager/partner at 610-687-1600 or [email protected] for additional information.

Author John J. Loughlin, Jr., CPA, is a partner and head of the Tax & Advisory Services Department at Stephano Slack, where he specializes in tax compliance and projections. John assists clients in navigating the complexities of tax compliance, providing clear direction that alleviates concerns and simplifies challenges. His expert advice instills confidence and peace of mind, ensuring clients know their tax matters are in good hands. John can be contacted at 610-710-4045 or [email protected].