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:
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:
- Searching for new properties
- Studying financial statements
- Managing the finances of an activity in a non-managerial capacity
- Preparing summaries of finances or operations
- 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:
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:
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:
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!