Who Counts as a Real Estate Professional?
For the Internal Revenue Service (IRS), owning a rental property does not automatically qualify you as a real estate professional. That designation may seem unimportant, but becoming a real estate professional can have a significant impact on your tax liability. Would your real estate investment business benefit from this designation? Today, we’ll review the benefits of being a real estate professional, the criteria for becoming one, and best practices for proving your professional status to the IRS.
Benefits of Being a Real Estate Professional
Say you have a full-time job, and your rental property is a side business. In this case, you aren’t able to deduct your passive losses against your active income. That’s because most real estate investments count as passive activities under IRS criteria. And, per the IRS, any wages, salary, or self-employment income count as active income. You may have to wait for future tax years to claim passive losses against your future passive profits. Plus, rental property owners sometimes are also subject to the net investment income tax, an additional 3.8 percent.
Because of this, some landlords prefer to qualify their rental businesses as an active activity. This allows them to deduct rental real estate losses against their other active income. With active activities, the IRS’s special $25,000 allowance limitation doesn’t apply. That means you can have more than $25,000 of active real estate losses. Plus, the modified adjusted gross income test and phase-out rules don’t apply. That’s beneficial for investors with large real estate portfolios. Investors who have significant active income from other sources benefit here as well. And as a real estate professional, you may not be subject to the net investment income tax. These exemptions add up to significant reductions for your tax liability.
But for your rental property business to qualify as an active activity, you must meet two conditions: the material participation test and the real estate professional qualification.
Material Participation Test
The material participation test checks for your regular, continuous, and substantial participation in your business throughout the year. To prove your material participation, you must meet one of the seven following tests.
1. You work in the activity for over 500 hours.
2. You do substantially all the work in the activity.
3. You took part in the activity for over 100 hours during the tax year. No one else worked on the activity more than you, including non-owners and employees.
4. The activity is a significant participation activity. You took part in all significant participation activities for over 500 hours.
a. Note: The IRS does not consider rental or leasing activity a significant participation activity.
5. You materially participated in the activity for any five of the prior ten years.
6. You materially participated in a personal service activity for any three prior years.
7. You took part in the activity on a regular, continuous, and substantial basis during the year, and you have supporting documentation to confirm that.
To pass this test, you must establish your material participation by reasonable methods. The IRS defines a “reasonable method” as having complete and accurate records. Appointment books, calendars, narrative summaries, and contemporaneous time logs all would support your material participation.
There are special considerations for limited partnerships and corporations, so speak with your tax preparer about how the material participation test can help your investment property business. For more details on material participation, see IRS Publication 925.
Real Estate Professional Designation
For your rental property business to qualify as an active activity, the second condition you must meet is the real estate professional qualification. This is not the same as being a Realtor or broker. The IRS will consider you to be a real estate professional if you meet these three criteria:
1. You must have 5 percent ownership of each property for which you claim to be a real estate professional.
2. Over 50 percent of your work must be in real estate property activity for the year.
3. You must work at least 750 hours in your business.
The catch comes if you own more than one rental property. If you claim to be a real estate professional for each of your properties, you must work at least 750 hours per each property. However, the IRS gives you the option to group all your properties as one activity. That reduces the time you must work, but once you elect to group your properties, you can’t change that election. (For more information on that election, see the Instructions for Schedule E (Form 1040), Supplemental Income and Loss.)
If you are married and filing jointly with your spouse, only one person must meet these criteria. That’s true even if the rental properties aren’t owned jointly. However, you may not combine your hours worked to meet the 750-hour minimum requirement.
Best Practices for Documentation
Thorough documentation is the best way to prove your material participation and your qualification as a real estate professional. If the IRS audits you, the burden is on you to provide proof of your activities. Show your compliance with the IRS standards by keeping complete, accurate records. It’s difficult to create detailed documentation after the fact, so keep track of your activities as you go.
Use a separate email account for your rental activities.
Have a call log, and take notes during your calls to describe their purpose.
Maintain separate bank accounts for your rental properties.
Keep a separate calendar detailing your time working in and outside of your rental business. Track your meetings, property visits, and events related to your rentals on the calendar. Detail the specific services you performed.
Track your income and expenses in accounting software, like REI Hub.
As you are tracking your time, be mindful that some activities won’t count toward the hours needed for the material participation test or the real estate professional qualification. The time you spend researching new rental opportunities doesn’t count. Time spent on call for tenants doesn’t qualify. The IRS doesn’t always consider travel time either, so be conservative if you include travel in your time log. If you aren’t sure if an activity should count for the material participation test or the real estate professional requirements, ask your tax preparer or lawyer.
Takeaways
The real estate professional designation is more than just a title. It’s part of a tax-savings strategy that shifts your real estate investment from a passive to an active activity. However, both the material participation test and the real estate professional designation require time and careful recordkeeping. If you need help keeping your rental property’s books and records in order, REI Hub is here to help. Our accounting software is configured for real estate investors, featuring property-centric reports, mileage logs, receipts and document storage, and lease tracking. Start your free trial today!
