The Real Estate Professional Tax Status: Do You Qualify? (2024)

Do you spend a lot of time in the real estate industry?

Maybe you are a property owner, and you enjoy managing rental properties and fixing problems that pop up. Maybe you work for a real estate developer finding deals and reviewing contracts. Maybe you are an investor with a significant portion of your portfolio committed to real estate projects.

Would you consider yourself a real estate professional?

More importantly, would the IRS agree? Or would they view you as a passive investor subject to the onerous passive loss rules?

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What is the Real Estate Professional Tax Status?

Rental real estate is considered a passive activity unless you meet one of the exceptions below. The Passive Loss Rules provide that a taxpayer’s losses from a “passive activity” may only be used to offset income from a passive activity.

A passive activity is “a trade or business in which the taxpayer does NOT materially participate,” and rental activities (i.e., activities in which payments are received principally for the use of tangible property) are inherently classified as passive activities.

This means any losses from a rental real estate activity can only be used to offset passive income.

However, there are two exceptions to this rule. The first exception allows for a limited $25,000 deduction for taxpayers with adjusted gross income under $150,000.

The second exception—commonly known as the real estate professional exception—allows certain individuals to be exempt from the general rule that all rental activities are passive.

Why does the Real Estate Professional Tax Status matter?

Significant tax advantages—including the ability to deduct losses against nonpassive income and avoidance of the 3.8% net investment income tax—could be available if you qualify as a real estate professional.

For example, if you incur a $100,000 rental real estate loss this year, you cannot deduct that loss unless you have at least $100,000 of passive income or sold the property.

However, if you qualified for the real estate professional tax status, you could deduct the $100,000 against your other income even without the presence of other passive income.

Deducting that loss could potentially be worth up to $40,000 in income tax savings.

Who Qualifies for the Real Estate Professional Tax Status?

To qualify for real estate professional tax status, you must meet both of the following criteria:

1. More than half of the personal services performed by the taxpayer during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates.
2. The taxpayer must perform more than 750 hours of services during the tax year in real property trades or businesses in which the taxpayer materially participates.

If these criteria are met, you qualify as a real estate professional, meaning you have overcome the presumption that all your rental activities are inherently passive.

But there is still one more hurdle to clear before deducting the rental loss.

One of the following seven material participation tests outlined by the IRS that apply to all other passive activities (non-rental activities) must still be met:

1. “You participated in the activity for more than 500 hours.
2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test.
5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
7. Based on all the facts and circ*mstances, you participated in the activity on a regular, continuous, and substantial basis during the year.”

For example, let’s say you own a successful real estate construction business that results in you meeting the criteria to be a real estate professional.You also have one rental property that results in a loss.Because you are a real estate professional, the rental loss is not automatically passive, but you still must meet one of the seven material participation tests for the rental loss to be nonpassive.

What constitutes a “real property trade or business” in the first criteria?

Section 469(c)(7)(C) defines a “real property trade or business” as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokeragetrade or business.

Do Employees of Real Property Businesses Qualify for the Real Estate Professional Tax Status?

Unless the employee is a greater-than-5% owner in the employer, the hours rendered as an employee do NOT count toward the one-half time and 750-hour tests needed to qualify for the real estate professional tax status.

If you own interests in real estate deals but provide your services through a management company that you do not own any interest in, you would potentially be excluded from the real estate professional tax status.

How would activities be treated as nonpassive?

Presumably, a real estate professional’s goal would be for rental activities to be treated as nonpassive.

For that to happen, the taxpayer must show that he or she materially participates in each separate rental activity, which could be difficult to accomplish in total if he or she has multiple activities.

However, a taxpayer can elect to treat all rental real estate activities as a single activity, rather than treating each rental property individually. This election is made with the taxpayer’s return and is binding for that tax year and all future years in which the taxpayer is a qualifying real estate professional.

How would I prove material participation in property trades or businesses?

Both criteria set forth under Section 469(c)(7) for the real estate professional tax status are facts-and-circ*mstances based. Maintaining comprehensive and organized records of your real estate activities is essential for proving material participation.

Track the number of hours you spend on each project or property, documenting your involvement in detail. Use tools like timesheets, calendars, and project management software to effectively monitor and record your activities.

The burden of proof is on you, the taxpayer, for proving compliance with the statutes.

Learn More about the Real Estate Professional Tax Status

While the real estate professional tax status can yield tax advantages, the technicalities of qualification and documentation are complex and not always clear.

Navigating the complexities of the tax code and understanding the nuances of material participation can be challenging. Consider consulting a CPA who specializes in real estate taxation for guidance on structuring your activities, maximizing tax benefits, and ensuring compliance with relevant regulations.

If you’d like to learn more about how the real estate professional tax status may apply to you, reach out to your Warren Averett advisor directly, or ask a member of our team to reach out to you.

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