What is a Real Estate Professional?
In tax terms, a Real Estate Professional (“REP”) is someone who meets two specific criteria laid out in the tax code. In order to be an REP:
- A taxpayer must spend more than 750 hours/year providing personal services in a “real property trade or business” (“RPTB”) in which they materially participate. If the taxpayer materially participates in multiple RPTBs, they can add them together when counting hours
- More than half of the taxpayer’s total “personal service” hours worked must have been spent materially participating in a “real property trade or business”
Before you can determine if you qualify, we should define a few terms used above:
- Real Property Trade or Business (“RPTB”) – In plain English, an RPTB is a business that is part of the real estate industry. The IRS’s guidance on what businesses qualify as an RPTB is hazy at best, but they do specifically include eleven businesses and specifically exclude one (see Appendix A below for a full list)
- Material Participation – In nontechnical terms, if you actively work at the company and provide services, you probably materially participate. If you are an outside or silent investor who doesn’t take part in running the company, you probably do not materially participate. Technically, there are seven tests to determine if you materially participate in an activity or group of activities (see Appendix B for all seven tests). Note that you only need to pass one of the tests to qualify
Note – A married taxpayer, even if filing a joint return, can only use his/her own hours when meeting the two criteria listed above and must not include hours performed by his/her spouse.
What’s the point of being classified as a Real Estate Professional?
In short, REPs may be able to classify income or losses from rental real estate as non-passive instead of as passive. Non-REPs must always classify rental income or losses as passive.
What’s so good about having rental activities classified as non-passive instead of passive?
There are two advantages to having non-passive income instead of passive income:
- Passive losses can only be used to offset passive income
- If you don’t have any passive income this year, your passive losses go unused and carry forward each year until you either have passive income to offset or you sell the activity/property
- Given that it is common for rental real estate to generate losses, taxpayers generally want to be able to use these losses to offset income generated elsewhere, such as the wages from their job or the profit from a company they own
- Converting the losses from rental real estate from passive to non-passive income allows the losses to offset income generated by other non-passive activities
- Unlike passive income, non-passive income is not subject to the 3.8% Net Investment Income Tax, which is an additional tax levied on certain types of income
I qualify as a Real Estate Professional and I am involved in rental real estate activities, does this mean they are automatically classified as non-passive?
No! This is a common misconception! There is one more important layer to get through before your rental activities are considered to be non-passive.
In order for a rental activity to be non-passive, the REP must materially participate in the activity. This may pose a problem for many REPs, since it’s common to work in real estate but have investments in rental activities on the side, and just being an investor isn’t enough to get passive treatment because of the lack of material participation.
However, there is hope! The IRS allows REPs to group all of their rental activities together for the purposes of passing one of the seven material participation tests (Appendix B). So, if you are actively involved in several rental activities such that your total hours participating add up to more than 500 (or you pass one of the other tests), you can group these activities with other rental activities in which you are only a silent investor, and because they are grouped, they are all treated as non-passive!
I’ve made it this far and I’m ready to make my rental activities non-passive, what do I do now?
- Track your time! While you are technically allowed to establish yourself as an REP using any “reasonable means”, the IRS has been explicitly told by the courts that they do not have to accept a “ballpark guestimate”, and you’re much more likely to stand up to any scrutiny if you have contemporaneous daily time reports or logs that can be corroborated by other records such as your calendar or datebook
- Determine whether you will be grouping your rental activities together, and if you decide to group, you must make the election on your tax return
What common pitfalls should I avoid?
- Past court cases have shown that it is very difficult for a taxpayer who has a full-time job in a non-real estate field to qualify as an REP. Due to the criteria requiring that more than half of your total hours be spent on real estate, the IRS and courts find it hard to believe that someone can spend upwards of 2,000 hours on their full-time job and still find time to spend more than that on their real estate activities. If this is the case for you, daily time reports are even more important!
- I’ve said it before, but it is worth repeating. Track your time! Track your hours in real-time at the end of each day or week instead of trying to backfill your schedule at year-end. It may sound ridiculous, but past cases have shown taxpayers losing their REP status in court because they:
- Were unable to provide credible records
- Provided records that were duplicative of each other
- Tried to twist or misrepresent the hours spent on their full-time job (a teacher claimed that the only hours that counted as working were those spent in the classroom, and that hours spent planning or meeting with kids should not be included)
- Overstated hours spent on certain activities (e.g. 56 hours to replace a toilet, 24 hours to replace four window blinds)
- Provided records that totaled to more than 24 hours in a single day
- Grouping your rental activities without considering your existing passive loss carry-overs. Normally, when you sell an activity, any passive losses that are being carried forward are freed up and used to offset the gain on the sale of the activity. However, once you’ve elected to group activities, none of the individual activities are considered “sold” (for the purposes of freeing up passive losses) until the whole group is sold, so you may inadvertently trap existing passive losses that otherwise would have been freed up when a single activity was sold off
In conclusion (tl;dr) –
Without question, this is a complicated and often confusing area of the tax code (and we’ve only scratched the surface of the some of the more nuanced areas of this section), but one that can potentially provide those working in real estate with significant tax savings. If you work in real estate and have income or losses from rental properties that you’d like to try to convert from passive to non-passive, let us know! We can help determine if the strategies we’ve discussed are a good fit for you.
Appendix A – Which businesses do the IRS consider to be Real Property Trades or Businesses?
- DOES qualify as an RPTB:
- Real property development
- DOES NOT qualify as an RPTB:
- Mortgage broker
Appendix B – The seven tests of material participation in an activity or group of activities in a given year (Note – you only need to pass one of the seven tests to qualify):
- Have more than 500 hours working on the activity (not to be confused with the 750 hour requirement to be a REP)
- All of the hours spent on an activity were spent by you (i.e. no one else spent any time on the activity)
- Have more than 100 hours on the activity AND no one else spent more time than you on the activity
- The activity is a “significant participation activity”, and your aggregate participation in all “significant participation activities” exceeds 500 hours
- Materially participate (by passing one of these tests) for at least 5 of the last 10 years (the five years may or may not be consecutive)
- The activity is a “personal service activity” and you materially participated (by passing one of these tests) for any three prior years
- Based on all of the facts and circumstances, you participate in the activity on a regular, continuous and substantial basis during the year
Notes about the material participation tests –
- Hours spent as an employee of a company do not count when calculating material participation unless the employee owns at least 5% of the company they are working for
- Hours spent as an investor in an RPTB (g. reviewing financials of an entity) do not count when calculating material participation unless the taxpayer is also involved in the day-to-day management of the business
- A married taxpayer is required to count any hours performed by his/her spouse when calculating material participation in an activity (this differs from the criteria to determine if a taxpayer is an REP)
- If the taxpayer holds an interest in an RPTB through a limited partnership, the taxpayer can only establish material participation in the activity by using tests #1, #5 or #6