Are You a Real Estate Professional?
I played baseball my entire childhood, all the way through high school. I enjoyed it and was fairly good at it, but I didn’t devote most of my time to it. Spoiler alert – I did not make it to the MLB as a professional baseball player.
While there is no REPL (Real Estate Professional League), you can still qualify as a real estate professional by meeting a certain set of criteria, which center mainly around the amount of time you devote to your real estate activities.
There are substantial benefits to making this election but there could be downfalls, too.
Before moving on, can we agree to abbreviate “real estate professional” to “RE pro” for my keyboard’s sake?
How to Qualify as a RE Pro
The IRS lists two requirements that must be met in order to qualify as a RE pro. Let’s first hear them straight from the horse’s mouth and then we’ll break them down further in normal person language.
To qualify as a RE pro, you must meet both of the following requirements:
- More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Let’s dive a little deeper…
“More than half of the personal services you performed…”
This means over 50% of personal services, which is basically any work you have done yourself or time you have spent. Personal services do not include those performed as an employee of a real property trade or business unless you owned 5% or more of the employing entity. Also, your spouse’s personal services do not count towards your determination of RE pro qualification; you cannot combine more than one person’s time or services to meet the requirements.
“…in all trades or businesses during the tax year…”
This one’s fun. As the IRS defines it, “a trade or business is generally an activity carried on for a livelihood or in good faith to make a profit”. The issue is that passive investments are generally not considered to be trades or “businesses because they don’t involve active, hands-on work. Since rental real estate is passive in nature, the determination of whether or not it is considered a trade or business differs on a case-by-case basis. For the purpose of this article, let’s assume your rental activity is considered a trade or business.
Also, the word “all” is important because it signifies that all of your activities combined are taken into account when determining the percentage of the personal services you performed throughout the year.
For example, if you have multiple small businesses, the time spent and personal services performed in each one (even if they’re not real-estate-related) are considered. Another example would be if you worked a full-time job as an employee – typically, that translates into 2,087 hours per year. That means you’d have to work at least 2,088 hours in a real property trade or business in which you materially participated. For this reason, full-time employees are usually disqualified.
“…were performed in real property trades or businesses…”
As if “trades or businesses” alone wasn’t murky enough… A real property trade or business is one that either develops, redevelops, constructs, reconstructs, acquires, converts, rents, leases, operates, manages, or brokers real property.
“…i“n which you materially participated.”
To get a better understanding of material participation, click here.
And that was only one requirement.
I’ll wait here if you need a quick break before moving on…
“You performed more than 750 hours of services during the tax year…”
You must spend at least 750 hours per year on your real property trade or business. By default, each property is treated as a separate activity, which means that you would have to meet the 750-hour requirement for each property. You can, however, elect under Section 469(c)(7)(A) to treat all rental real estate interests as a one, single activity.
“…in real property trades or businesses in which you materially participated.”
Real property trades or businesses and material participation are used in the same context as Requirement #1.
The main advantages of qualifying as a RE pro are as follows:
- Your passive rentals will be treated as active trades or businesses, which means rental losses will not be subject to the passive activity loss limit”ations, and will be fully deductible against nonpassive income.
- If you file a joint return, only one spouse has to qualify as a RE pro to reap the benefits and deduct the losses against all joint income.
- If your rental activity was subject to the 3.8% net investment income tax (NIIT), being a RE pro eliminates that extra tax.
The main disadvantages are as follows:
- If your real property trade or business is generating positive taxable income, there will be no major benefit to qualifying as a RE pro, considering the main advantage of the qualification is the ability to deduct rental losses in full.
- Electing to treat all rental activities as a single activity is a common course of action if you have more than a couple rental properties. This election could cause problems upon the sale of a single property. Generally, upon the sale of a rental property, any suspended passive losses related to that property are “freed up” and deductible in the year of sale. If you make the grouping election, however, you lose the ability to free up passive losses upon the sale of a rental property.
- The election is irrevocable; once it is made, it can’t be undone.
Keep Detailed Records!
I won’t sugarcoat it – the RE pro status is highly scrutinized by the IRS. You MUST keep detailed records that prove you qualify as a RE pro. The most important factor in determining whether or not you’re a RE pro is your time—over 50% of your time and at least 750 hours per year must be spent in real estate activities—and you must track this time.
You can keep a daily journal or diary, timesheets, spreadsheets, digital calendar, etc. to track your time – the more details, the better. Break out your time in blocks and keep notes of exactly what you did during those time blocks.
Like anything else, preparation is the key to success. Audits are not scary if you’re prepared; don’t wait until you get audited to start keeping detailed records.
Don’t Try This at Home
If you think you may qualify as a real estate professional, hire a tax professional. Do not try to tackle the qualification and elections yourself. Hire an experienced, real-estate-savvy CPA who will make sure everything is being reported correctly.
This is especially important if you currently have properties with suspended passive losses. Careful analysis must be done to weigh the pros and cons of qualifying as a RE pro and making a group election in this case.
Now, back to perfecting my swing in case the Yankees call…