The final section of our real estate saga has arrived. For those of you with no interest in real estate that have been tuning out the last several weeks, I’ll welcome you back next week with some captivating new content. For those of you that have never opened a single one of my emails, just keep doing you. You are doing wonders for my dream of never having advertisers sponsor this newsletter.
What is the real estate professional designation?
This designation is something that you mark on your taxes to notify the IRS that you’re not like the rest of us. If you remember from previous articles, the rest of us are limited in the amount of losses we can deduct from passive activities depending on our income. In other words, if I have losses on my rental property and have no other rental property income to offset it, I may end up having to suspend the loss into the future until I have passive activity income or until I sell the property. This limitation kicks in at $125,000 of modified adjusted gross income.
By claiming the real estate professional designation, you are basically saying that you spend SO much time on real estate activities that it can’t really be considered a passive activity for you. This allows you to deduct your losses in the year incurred regardless of the passive activity income that you have during the year. This can be very beneficial in the years that you make any substantial improvements or investments in your properties because it may allow you to reap the benefits of accelerated depreciation. This designation doesn’t do much in the years where all your properties are profitable, but can still get you out of the 3.8% net investment income tax that is due for some taxpayers on rental property profits.
The IRS is pretty specific about how to qualify as a real estate professional due to the fact that it’s one of the more commonly abused sections of the tax code. In order to qualify, you have to meet two tests.
The first is that more than half of the total personal services that you perform in ALL trades or businesses throughout the year must be performed in real property trades or businesses. In other words, you must spend more than half of your time working on your real estate activities. If you have a full-time job outside of owning real estate, tax court cases have demonstrated that it’s VERY difficult to justify the real estate professional designation. You must carefully document how many working hours you spend on all activities by keeping a daily log and totaling each activity for the year. Without these records, taxpayers historically lose the designation during an audit.
The second test is the 750 hours test. In order to qualify, you must spend AT LEAST 750 hours on real estate trades or businesses each year. Again, the important thing is to track your hours spent on each activity. You must also materially participate in each trade or business separately, so it may make sense to bundle your activities together in order to meet the material participation tests.
Should I claim it?
Again, this is one of the more abused sections of the tax code, and the IRS is well aware of it. Putting the real estate professional designation on your tax return would almost certainly put you at higher risk for an audit. However, if you truly are a real estate professional, it’s worth claiming this designation. It will help you get around the passive-activity loss trap that many investors deal with, and can also save you money in net investment income taxes. Just be sure to keep track of ALL of your hours throughout the year so you can substantiate the position in case of an audit.