By Dr. James M. Dahle, WCI Founder
Lots of high-income professionals involved in direct real estate investing get really excited when they learn about qualifying themselves or their spouse as a real estate professional. The general presumption by the IRS is that real estate rental activities are passive, and passive losses cannot be used against active income, i.e. the income from your W-2 job. However, if you (or your spouse if you file jointly) qualify for Real Estate Professional Status (REPS), you could use depreciation losses from your real estate investments against your normally highly taxed professional income, reducing your taxes dramatically—potentially even to $0.
However, this is not nearly as easy to do as you might imagine. If you claim REPS inappropriately and then are audited, you may find yourself paying hundreds of thousands of dollars in taxes, penalties, and interest. This can be a huge deduction, so it pays to really understand the rules surrounding REPS.
Requirements to be Eligible for Real Estate Professional Status (REPS)
There are three main requirements to claim REPS.
- 750-Hour Rule
- Greater Than Half of Professional Time Rule
- Material Participation
Let's go through each in turn.
#1 750-Hour Rule
You must spend at least 750 hours on “real property trades or businesses” during the year. Wondering what activities qualify for real estate professional status? What does that mean exactly? What counts and what doesn't? Well, the IRS tells you what counts:
- Development
- Redevelopment
- Construction
- Reconstruction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage
What do all those things have in common? They're WORK activities, not INVESTMENT activities. On the other hand, the activities you may think of when you think of real estate investing, including:
- Education
- Searching for new properties
- Studying financial statements
- Managing the finances of an activity in a non-managerial capacity
- Preparing summaries of finances or operations
- Commuting
- Work done “primarily for the purpose of avoiding disallowance of losses”
don't count. It's not 750+ hours of being a real estate investor. It's 750+ hours of being a real estate worker. You know, the person pounding the nails, signing leases, showing houses to clients, and filling out the paperwork.
Seven-hundred fifty hours. Assuming you take four weeks off, that's 16 hours a week. Two full work days. Every week. This is not a trivial requirement. And guess what the IRS is going to want to see if it audits you? That's right: a log or time card.
If you are an employee, those hours don't count either, unless you are also a 5%+ owner of the business/property.
#2 Greater Than Half of Professional Time Rule
The IRS doesn't want real estate to be your side gig. It has to be your main gig. You have to spend at least 750 hours doing this, and you also can't spend more time doing anything else than you do real estate. That means 750 hours of real estate management plus 1,000 hours of doctoring or lawyering is a non-starter. The problem with this requirement: not only does it make it hard to qualify for REPS, but it also makes REPS much less valuable, because there is less earned income to shelter with those real estate depreciation losses. It's hard to earn as much when you can't work more than 750 hours at it. This is why you see a lot of married couples specialize. Perhaps she is a high-earning physician, and he qualifies for REPS by managing their 15 rental properties.
#3 Material Participation
Finally (and this is where I suspect a lot of people are cheating), you have to actually materially participate in each real estate “activity”, i.e. business or property. Did you get that? You must qualify as “materially participating” for each property or business or activity where you're trying to use depreciation losses against your active income. If you hired a property manager for six of your 10 rental properties, those six probably aren't going to count. You are allowed to combine all of your properties/activities using a “grouping election,” but then the rules below must still be applied to the entire group of activities.
The time your spouse puts in doesn't count toward the 750-hour requirement, but it can count toward the material participation requirement. To qualify as materially participating, your activity must be on a “regular, continuous, and substantial basis.” There are seven tests that the IRS uses to determine this. You only need to qualify for one of them.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity (other than by meeting this fifth test) for any five (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
Practically speaking, what does this mean? If you own rental properties, it means you're doing all the work on them instead of doctoring with that time and hiring a property manager. You're maintaining, you're renovating, you're leasing, you're managing, etc. Get the picture? Yes, you can get some help, but then you'd better be spending at least 100 hours on that property during the year and more than anyone else. If a doctor makes $200 an hour, that means you're spending at least $20,000 worth of your time on a given property. That would more than eat up all of the profit on most smaller properties and substantially reduce it even on more expensive properties. And that's aside from the fact that you probably didn't go to medical school because you wanted to be a property manager.
More information here:
A Beginner’s Guide to Investing in Real Estate
How Many Properties Do You Need to Qualify for Real Estate Professional Status?
Now, if you are really efficient and can manage your properties in just 10 or 20 hours a year and you do everything, then you can qualify for material participation. But you're still going to have to meet that 750-hour requirement; 750 hours divided by 15 hours per property is 50 properties! Even if you're spending 100 hours per property (two hours per week), that's still eight properties. I think it's just going to be really difficult to claim REPS with fewer than that unless you are personally doing a massive amount of rehab work on the properties. Again, remind me why you went to medical school.
More information here:
How We Became Accidental Landlords
Real Estate Professional Tax Deduction
OK, let's say through some miracle (or more likely a career change or a spouse who does all this), you qualify for REPS and get to take this deduction. What is it exactly?
Joe Average can deduct up to $25,000 per year in passive losses against his ordinary income. However, that phases out between an income of $100,000-$150,000, no matter whether you are single or married. So, most WCI readers can't use passive losses against their ordinary income unless they qualify for REPS. Then, they can. Let's say you bought a $1 million property this year, and, thanks to bonus depreciation, you could depreciate $400,000 of it. If you (or more likely your spouse) had $400,000 in clinical income, you could subtract that depreciation from it when calculating your taxable income. Voila! No taxes due. At least this year. Remember that depreciation is recaptured when/if you sell at up to 25%.
You also do not have to pay Net Investment Income Tax (3.8% on investment income over $200,000 [$250,000 MFJ]) on income from this real estate activity.
Short-Term Rental Loophole
There is a way around this REPS 750-hour requirement. Short-term rentals (i.e. Airbnb and Vrbo) are not considered “rental activities” where the presumption is that the income is passive until proven otherwise. It's more like the IRS sees you as running a hotel (which you are.) This is generally defined as an average stay of seven days or less or an average stay of less than 30 days AND you provide substantial services to them (such as breakfast or daily maid service). If that's what you're doing, you're exempt from the 750-hour rule and the half of professional time rule. You still have to materially participate. Be careful with providing substantial services, too; if you do, your income will be subject to payroll taxes such as Social Security and Medicare.
So, keep stays to less than seven days on average, don't provide substantial services, and manage it all yourself. Then, you can write all that bonus depreciation off against your ordinary income. Once you use all that bonus depreciation up after a year or two, THEN you can convert the property to a long-term rental. Voila—the short-term rental loophole.
More information here:
Your Guide to Short-Term Rentals
Do Passive Investments Qualify for Real Estate Professional Status?
Many of us don't invest directly in real estate; we invest via syndications, private funds, and privately or publicly traded REITS. We may also get substantial depreciation passed on to us, via our K-1s. What does it take to use that? Well, the same thing. You need REPS status AND you need to materially participate in each of those activities. As a general rule, if you are a limited partner in the activity (which is the way most syndications and private funds are set up), you are considered not to have materially participated. However, if you met rules No. 1, No. 5, or No. 6 above, you may still qualify. But seriously, if you put 500 hours into one of your syndications, I hope you're getting part of the “promote” fees as a general partner.
Whether you do long-term rentals, short-term rentals, or syndications, you're not going to qualify for these REPS tax breaks if you're viewing these properties primarily as an investment. If you're viewing them as your (or your spouse's) main job (or, in the case of a short-term rental, a significant second job), then you may very well qualify. Keep good records of your time and activities performed; you'll need them in an audit.
Don't forget to sign up for the free White Coat Investor Real Estate Newsletter that will alert you to opportunities to invest in private real estate syndications and funds, including most of those I invest in.
What do you think? Do you or your spouse qualify for REPS to deduct your losses? How did you arrange your life to do that? Comment below!
One thing to mention is that if you are claiming REPS status AND do the grouping election, investment in syndications as an LP is no longer considered passive. Therefore you can use losses from syndications against ordinary income without having to materially participate. For example, you are a high income professional and your spouse is the real estate professional doing single family rentals. You meet the 750 hour test in your rental activities and materially participate, and do the grouping election. You also invest in syndications as an LP and maybe spend 10 hours per year vetting deals etc. the losses from the syndications will be used against your ordinary income.
Good point.
Do you know if this also works for the short term rental loophole? Or only for regular REPS status?
Re: Passive investments qualifying for REPS:
Although it’s been over a year, I’ve listened to multiple podcasts regarding REPS. If I remember correctly, there is a way to qualify your passive income / loss from syndications / private funds as active (and thus allow subtraction from your ordinary income).
1). You have to legitimately acquire REPS status via direct real estate investing. Typically this is done by self managing local properties as Jim has outlined in this post.
2). Group your income / losses from your other passive syndications / funds with your direct real estate. I believe this is accomplished by taking a “minus 9” election on some tax form (section 469 of the tax code).
This was our plan. But we quickly realized the difficulty of having 4 kids and obtaining REPS with a local rental collection. Hope this helps somebody!
It will be interesting to see if this will be an area of focus for all those new IRS auditors coming on board in the next few years.
We have been investing in real estate for decades. We bought our first investment property way back when I was still a resident, then slowly added additional properties over time.
For years, we had depreciation related passive losses, and as the rents rose and the profits increased, we slowly used up those carry forward passive losses. We also started a health care related business that has become increasingly successful, leading to 7 figure income tax bills every year.
Last year we bought a lot of residential and commercial RE that threw off outsize bonus depreciation deductions through cost segregation. We planned in advance to come up with a strategy that would allow IRS compliant, bullet proof qualification for REPS. That led to saving a 7-figure amount of income taxes.
I am a FT healthcare worker. My spouse is retired and loves doing renovations and interior design. So in addition to the purchase of some large commercial properties, we specifically bought a townhouse in our local VHCOL area to allow my spouse to qualify for REPS . My spouse was the GC on the whole house renovation. We thought it would be a pretty much break even deal, but we bought the tired interior townhouse for 800k , put a bit more than 200k into the renovation, and then rented it out for 8,500 per month. We were also offered 1.45MM to buy it, which would have led to a nice 400k profit, but that profit would be taxable as regular income. Instead we are renting it out, with a plan to sell in the future and then 1031 exchange into another property.
We will likely go all passive in the coming years by selling with 1031 exchanges into passive RE partnerships. The returns can run anywhere from 15 to 30% per year, and that is a great way to build wealth. But RE success requires knowledge of many moving parts and is more like running a business. It is way more passive than providing patient care, but way more active than investing in an index fund. When done well, the tax benefits and the profits far exceed stock market returns, but it isn’t for everyone.
SO you can do a 1031 exchange of an active rental property that you own and rent out, sell it, and put it into a passive real estate fund? Can the passive fund be a REIT? Can you elaborate more on this idea?
Thanks
That’s called a 721 exchange and the REIT has to take the rental property.
You can sometimes 1031 into a partnership, but there is a lot of extra paperwork and legal work involved. Most RE syndications do not accept 1031 exchanges from their limited partners. However, once you start talking 7-figure amounts of investments, some syndications will make exceptions due to the larger investment amount.
Is this a problem area? I mean, has “Real Estate Professional Status” been an area that gets audited very often? Or is it instead like tax-loss harvesting… a somewhat vague requirement that does not seem to draw any audits?
Good question. I don’t think I’m qualified to answer it. Perhaps an accountant who specializes in working with real estate investors might be able to.
This is a heavily audited area in the tax code. I believe this area of the code has the highest or one of the highest number of IRS court cases. I would suspect that this will continue to be a heavily audited section of the tax code going forward, since there are many pitfalls several of which were outlined in this post. You really need to either devote tremendous effort to learn it, or you need to hire an accountant who is knowledgeable in this area, or do both.
Great article. Question about “Remember that depreciation is recaptured when/if you sell at up to 25%.” Other than 1031 exchange to defer recapture, isn’t it exactly 25% or is there some way to lower or avoid it? Why is it “up to” 25%? Thank you.
3 types of recapture:
1245 – taxed at ordinary tax rates (this is personal property typically 5 and 7 year property)
1250 – taxed at ordinary rates. This is any depreciation that is in excess of straight line (from bonus depreciation of say 15 year property)
Unrecaptured 1250 gain – this is your building which for residential is 27.5 years. This is taxed at a maximum of 25% (scales up based on income level)
It’s your ordinary income tax rates with a cap at 25%.
Really enjoyed the article.
I had no idea about the short term rental loophole for REP status. It seems like a must-do for any physician with a serious real estate portfolio.
Great summary of the REPS status requirements.
Do you have any perspective on whether electing REPS is more likely to trigger an audit? I haven’t tried to elect this yet, but don’t want extra scrutiny (already have FBAR and FATCA filings) for what might be not a lot of gain.
I believe I qualify as an early retiree who runs an LLC of 5 rental properties (3 property managed) for the benefit of a family trust, in addition to 2 personally owned (1 property managed, 1 personally managed) and a vacation property (rented out two summers but not this past one). The amount of bookkeeping and tax filings (getting K-1s out, dealing with beneficiaries), decisions on improvements/repairs, etc have turned into a full-blown part time job. Also have to manage a commercial property directly in a foreign country. I have no other active income, so all income received is from landlording and stock dividends/interest.
I don’t really know, but a previous commenter who seemed to said yes.
Personally, I wouldn’t let fear of an audit keep you from claiming a deduction you legitimately deserve.
If you have professional management, those properties do not count towards hours for REPS. So it sounds like you would have to fire the professional managers and manage those properties yourself if you want to qualify for REPS.
Is this true? Can you please point to the IRS code that explains this aspect? I have property managers for certain tasks, but maintenance management is on me. When a tenant reports an issue, it comes to me and I work with the tenant (and service providers, if necessary) to resolve the matter. I learnt the hard way that property managers take the path of least resistance. Determining rents for new listings based on market conditions and competitor listings is another time consuming job. Are you saying that all the work that’s done do not count because there is a property manager? Doesn’t sound right to me. I treat the prop mgr more like an insurance policy for emergency situations I can’t handle remotely.
Me and my wife have been hit on our schedule E, my tax preparation guy screwed us, but I have a question? I do all the property management for are rental property. I do the maintenance and all up keep, I answer all the phone calls and deal with any issues that may arise with the hoard and our tenant. I feel im working over 500 hrs a year dealing with our rental. What should be do, this cost us 13k on our 2019 return and we just got notice for the exact same thing on our 2020 return.
Please help
My partner is a w2 employee doing property management full time for an unrelated company. We also have a rental.
If she incorporated and did property management work on contract, I believe she would qualify.
Would we then be able to deduct our personal rental depreciation?
I’m not even sure she needs to become an independent contractor to qualify. Did I miss something where it says employees don’t qualify for some reason?
My husband and I are in this same scenario. Did you get clarification on this?
Maybe this is a naive question, but how does the Alternative Minimum Tax play into this?
I don’t think it really does. What am I missing?
At any rate, AMT is hitting so few people these days is it even an issue for you?
Is another drawback of the REP the self employment tax?
I’m assuming most own their real estate in a single member LLC. If a person designates as a real estate professional, and now the income is not passive, does this mean you have to pay self employment tax at 15.3%?
Assuming you aren’t benefiting from offsetting losses because your rentals make income, are you worse off? You don’t pay the Net Investment Tax of 3.8% but do pay self employment tax at 15.3%?
I think you can get REPS status without taking that income as earned income. But even if you had earned income, the point of REPS status is to offset all your earned income using depreciation.
Thank you for the great article. My question is that if the property is hold 50%/50% between husband and wife, and the wife qualify for the REPS, is only her 50% depreciation loss can be passed on to offset the husband W2 income? For example, if the depreciation is $100k, will only $50k loss be passed on to offset the W2 income from the husband?
Great question. I don’t know for sure, but I think it’s fine. However, if it wasn’t you could just have the husband gift the wife his half of the property and she could gift it back later.
I believe commuting/traveling can actually count toward the 750 hours assuming you have a home office in place. See case details below.
https://bcocpa.com/travel-time-counts-real-estate-professional-time-tests/#:~:text=Previous%20Next-,Travel%20Time%20Can%20Count%20for%20Real%20Estate%20Professional%20750%2DHour,as%20a%20real%20estate%20professional.
I am a physician, my spouse is a realtor. We file jointly on our taxes. I acquired a property that my spouse renovated and managed himself. His name is NOT on the deed, but we are legally married. My CPA says he can NOT count the hours of renovations/management of the property towards his real estate professional status because he doesn’t own any percentage of the property . Does that sound correct?
That doesn’t sound right to me. I think I’d get a second opinion. It’s beyond me why that property is in the name of the doc in this relationship though. That would have been my last choice. LLC first, then the spouse least likely to get sued, then both spouses, and finally the doc.
How do we apply for REPS. Is there an IRS form or application to be submitted to the IRS? Thanks
Good question. I had to look it up. Per
https://www.aicpa-cima.com/resources/article/tax-rules-for-real-estate-professionals