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To qualify as a real estate professional, a taxpayer must meet the following two criteria (IRC Sec. 469(c)(7)(B):
This is straight form IRS Passive Activity Loss Audit Technique Guide (Doc p2-4, PDF p.27)
A real estate professional must materially participate in each rental activity for the loss to be deductible
Exception: A real estate professional may file a written election to group all rental real estate activities as one activity. As a practical matter, most elections were filed in 1995. However, the taxpayer may file the election in any year, and it will bind future years from that point.
To be a real estate professional, an individual must spend the majority of his or her time in real property businesses:
The taxpayer must meet each of the following two time requirements:
[6] One spouse alone must meet both tests. In addition, services performed as an employee do not count unless the employee is at least a 5 percent owner. Finally, before rental losses are deductible without being limited by the passive losses rules, the taxpayer must materially participate in each rental.
Material Participation for Real Estate Pros - A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. [8] The material participation test[9] then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on IRS Form 8582
This article will outline the basics of what REPS is, who can claim it, and finally highlight some of the common traps investors can fall into. It is important to remember this is just a guide. Your situation is unique, and we highly recommend speaking to an experienced tax professional prior to taking this strategy. Most real estate investors have heard of the Real Estate Professional Status (or REPS). However, most investors do not fully understand how complex this status can be and why it is so difficult to claim.
The real estate professional status allows investors the ability to save by converting passive tax losses and using them against active income. To do this, they must show 750 hours of material participation in their portfolio and spend more than half of their time working in a designated real estate profession. There are some intricacies regarding married couples and ownership we will also discuss. For full-time W-2 workers this status is extremely difficult to achieve and requires impeccable record keeping. Should an investor ever get audited they will bear the full burden of proof and face steep penalties should their defense fail.
Similar to The Short-Term Rental Loophole, REPS allows investors to claim traditionally passive income, and make it active. The losses sustained from running these businesses can then be used to offset non-passive income, like W-2 income. In this way, a high-income earner could reduce their tax bracket by showing portfolio losses.
To qualify as a real estate professional, a taxpayer must meet the following two criteria (IRC Sec. 469(c)(7)(B):
This comes directly from IRS Passive Activity Loss Audit Technique Guide (Doc p2-4, PDF p.27) which we encourage investors to read if they are considering the REPS status.
Section 469 also goes on to say that investors need to meet both criteria on their own to qualify for REPS. Therefore, if you are spending more than one-half of your time in real estate and your spouse is performing more than 750 hours of material participation then this status could not be claimed. Next, we will examine each criteria more closely.
For Criteria 1. Investors need to be able to substantiate that more than half of their time is being spent in real estate. If a W-2 employee is working 40 hours a week at their W-2 job, then they must be able to prove they are working at least 41 hours a week in real estate activities. While some individuals may be able to sustain an 81 hour work week, the majority of taxpayers cannot and as a result the IRS is going to be skeptical. Part time W-2 workers will have an easier time showing that they have spent more than half their time working in real estate. However, they still need to keep records proving their efforts
Recent court cases have highlighted a trend of investors overestimating the time they spend materially participating in their portfolio while underestimating the amount of time spent at their day job. This specifically applies to full time employees such as firefighters, shift workers, pilots and schoolteachers, or those who worked seasonal jobs which left them with extra time that could be spent in real estate. Be cognisant that if you are submitting a timesheet to an employer, the same hours cannot be used to substantiate your material participation in real estate. For example, a firefighter would not be able to use the hours they are on call at the firehouse to meet Criteria 1 because these hours are also being used to calculate their time spent away from real estate. As a result, it can be extremely difficult for full and even part time employees to meet Criteria 1.
Criteria 2. says the taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer participates. These include:
For these activities to count the investor also must have at least a 5% ownership in the property they are working on.
It might be surprising for many to learn that the activities and material participation spent on short term rentals will not apply towards the Real Estate Professional Status. So, what activities do count when claiming REPS? A good rule is to ask “If this task was not done, would the business still be able to continue running?” When we ask this, activities such as repairs, building maintenance, and working with tenants should stand out as necessary. Therefore these activities would count towards meeting the 750 hour requirement. Activities that would be disregarded would be research or investor hours. For example, the time you spend browsing for new properties on Zillow.
Also of note, the IRS expressly says that activities that are performed for the express purpose of meeting minimum time requirements for REPS will not count. So, if you are performing busy work for the sole purpose of getting enough hours, I would stop now.
The list of activities that do and do not count is rather extensive. We won’t cover all of them here, but would encourage all readers to consult with your tax professional on the activities you plan to perform to ensure success. Learn more about hours that count and how to track your hours.
A real estate professional may deduct real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. The material participation test then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive, and losses (or income) go on IRS Form 8582
We have already written extensively on material participation and encourage you to read more here. However, material participation is very important to this topic. We also wanted to highlight that investors may need to group their portfolio, so they do not have to meet both criteria for REPS with a single property.
We have already talked about needing to meet both requirements for Real Estate Professional Status on your own. However, when it comes to material participation the IRS is willing to include the spouse’s material participation.
Key to any tax strategy is impeccable record keeping that can be used to substantiate your hard work. When keeping these records taxpayers should be as detailed as possible. When the IRS has thrown out records in the past it has often been because the records lacked detail or credibility. In one case, the owner had gone back and filled out his log years later and the court did not accept it because it was not contemporaneous to when the activity was performed. Also it is critical to not estimate your time and be as exact as possible. The IRS will see it as very suspicious if all of your activities are neatly rounded to hour or half hour increments, and this could be used to show a lack of credibility. Your timesheets and activity trackers should be made under the pretense that this will be examined by the court and so it needs to be flawless. If you want to learn more, Digb has another blog post on record keeping that can be found here.
The IRS tends to heavily scrutinize taxpayers who claim REPS status. If a Taxpayer gets audited it is important that they are prepared. Because of this, Digb does not recommend that taxpayers take this strategy lightly. The ability to offset W-2 income is so powerful the IRS is very focused on ensuring this strategy is not misused.
The most common mistakes in claiming REPS are not being able to meet both requirements. Usually this is due to poor record keeping or misunderstanding the requirements. Other common mistakes include believing you qualify for REPS because of certifications such as having a real estate license.
If an investor claims REPS and is deemed by the IRS to not qualify they will lose the previously taken tax benefits. The investor may also be responsible for large legal fees if they fail to win their court case.
Also, it is important to remember that material participation is equally important in this strategy, and it may be necessary to group your portfolio together to meet material participation requirements.
Finally, the mistake we see most often is investors attempting to follow this strategy without performing the necessary research and education. If you need help getting started feel free to reach out to Digb, and we would love to help.
The Real Estate Professional status is coveted for a reason. By qualifying for REPS investors have access to one of the most powerful strategies a taxpayer can take. While this is an effective strategy it is extremely hard to qualify for and is highly scrutinized by the IRS. Taxpayers should ensure they are well prepared and educated prior to embarking on this journey. Contrary to popular belief, REPS status takes a substantial amount of work to claim. When claiming REPS, you should absolutely consult with an experienced tax professional.
This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Your situation may be different; consult a professional for information concerning your individual tax, financial, or legal situation before taking any action.
