As I talked about in my Triple Net (NNN) lease post, sometimes I write based on experience and other times based on research. This is a research-based post looking at the qualifications for real estate professionals. I got interested in the topic after reading some articles online and discussions in online forums where physicians talked about obtaining real estate professional status for tax purposes.
What are the Benefits?
Real estate is a great way to build wealth either through direct ownership or more passive routes like crowdfunding or syndications. Physicians and other high-income professionals are always looking for ways to maximize our tax-advantaged investments and keep their tax bill low. Most of the time this in the form of retirement accounts like a 401K, 403b, Roth IRA, HSA etc. After maxing out these accounts, we look for other investment options and real estate quickly floats to the top.
Tax efficiency is one of the main advantages of investing in real estate. With the magic of depreciation, you can take an investment that is profitable on a cash-flow basis but then declared as a loss on your taxes after accounting for depreciation. If you use the cost segregation strategy for accelerated depreciation then you can end up with a significant loss to show on your taxes. The problem is that real estate losses are considered passive and can only be used to offset passive income/profit unless you claim real estate professional status (REPS).
Making Passive Losses Active
Based on Internal Revenue Code Section 469, rental activity is considered a passive activity if the taxpayer does not have “material participation” in the business. Passive Activity Loss (PAL) can only offset Passive Activity Income which is great for the rental property but doesn’t do anything for your active income from your w2 job. The passive income gets offset but if you have excess losses it just gets suspended and carried to the following year.
Example #1:Traditional ScenarioNow, what if we could use our passive losses to offset our regular w2 income by claiming Real Estate Professional Status (REPS).
Annual Gross Income (AGI): $300,000
Passive losses from Real Estate: $50,000 (suspended)
Tax Liability: ~$55,000
Example #2:Real Estate Professional Status Scenario
Annual W2 Income: $300,000
Passive losses from Real Estate: $50,000
Taxable Income: $250,000
Tax Liability: ~$42,000
As you can easily see this reduces the tax liability by $13,000 without any changes to the cash flows. Over time the real estate portfolio will grow and possibly allow for more losses and further reduce your tax bill. Not only are you reducing your taxable income, moving into lower tax brackets which can have an impact on your long-term capital gains rate
Do I Need a License?
Whenever this is presented the first question that comes up is how do I get the certification or license to become a REP? While real estate agents and brokers are the most common REPs the reality is that you don’t need a license. REPS is a tax designation that has some qualifying criteria but it does not require a license or an exam. Great! How do I qualify?
- Greater than 50% of all personal services performed during the tax year were “real estate trade” on the rental property (material participation)
- Greater than 750 hours of “real estate trade” were performed on the rental properties in which you materially participated
Real estate trade activities can be property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. You can have property managers but you have to be directly responsible for their work instead of a crowdfunding or syndication deal where you are a limited partner and the syndicator interacts with the property manager.
The other criteria to keep in mind is that the two qualifications above are technically for each rental property. If you have 4 rental properties then you need to spend 3000+ hours on the real estate trade unless you declare all of your properties as one entity. The is mostly a declaration on your taxes that your CPA can take care of easily but just don’t forget.
Executing the REPS will depend on your personal situation at home. Are you married? Does you spouse work? Are you able to work part-time?
- Single: You may need to cut back at your W2 job to satisfy the 50% and the 750-hour rule for material participation. If you work 1600 hours full-time then you would need to spend 1600+ hours on real estate to qualify.
- Married: This is probably the most common scenario among physician families. One spouse can do real estate full-time while the other spouse works full-time thus allowing the real estate losses to offset the W2 income.
How Do I Get Started?
- The first step would be owning direct real estate. Crowdfunding and syndications are great ways to invest passively but don’t expect to apply for real estate professional status.
- Find a real estate accountant who understands REPS and can help file your taxes appropriately.
- Keep growing your portfolio to increase your passive losses and offset your w2 income