Who Can Save Taxes as a Real Estate Professional?

If you are engaged in real estate activity at any level, you may be entitled to significant tax savings if you qualify as a “Real Estate Professional” (REP) under IRS requirements. If a taxpayer does meet IRS requirements to qualify as an REP, it allows the taxpayer to utilize losses from a real property trade or business to offset other ordinary income, such as wages. Without REP status, such losses would be subject to passive activity loss rules which would limit this ability. It is therefore advantageous to determine if you can qualify as an REP.

Do I Qualify as a Real Estate Professional?

IRC Section 469(c)(7)(B) provides two tests a taxpayer must satisfy in order to qualify as an REP:

1.      More than half of the taxpayer's personal services performed in trades or business during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates (the 50% test); and

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 (the 750 hours test).

The term “real property trade or business” as referenced in the language above means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Because determining whether a taxpayer has “materially participated” in each rental activity is required in both the 50% test and the 750 hours test, practitioners typically consider material participation as a third and separate test of REP qualification (the material participation test).

A taxpayer shall be treated as “materially participating” in an activity only if the taxpayer is involved in the operations of the activity on a basis which is “regular, continuous, and substantial”. The Regulations under Section 469 expand on this definition and provide that to be considered a “material participant,” a taxpayer must satisfy at least one of the following:

1. Taxpayer works more than 500 hours in the activity;

2. Taxpayer does substantially all of the work in the activity;

3. Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees);

4. The activity is a significant participation activity (SPA), and the taxpayer’s total time in all SPAs exceeds 500 hours. Rental or leasing activity is not considered an SPA;

5. Taxpayer materially participates in the activity in any five of the prior ten years;

6. Taxpayer materially participates in a personal service activity for any three prior years; or

7. Based on all facts and circumstances, taxpayer participates in the activity on a regular, continuous and substantial basis during such year.

Documentation / Methods of Proof

The tax savings and other benefits provided by qualifying as an REP are significant and therefore the IRS has historically exhibited increased scrutiny over taxpayers claiming such status. Accordingly, maintaining thorough records which establish total hours spent working in real estate and material participation is very important.

Temporary Regulations under Section 469 provide that the extent of an individual’s participation in an activity may be established by any reasonable means. Therefore, contemporaneous daily time reports, logs or similar documents may not be required if the extent of such participation may be established by other reasonable means.

Reasonable ways of proving participation might include identifying services performed over a period of time and estimating the number of hours spent, using things like appointment books, calendars, or written summaries, etc.

Case by Case Determinations

While the REP qualifying tests are in some senses straight-forward, there are many nuances in their application which can significantly affect a taxpayer’s qualification. For example, there may be circumstances where a spouse’s hours may be counted and others where they cannot be. There is an election available to treat all interests as a single "real estate" activity, or you can apply the material participation test separately for each rental property. Knowing whether a separate or combined analysis is better depends on a case-by-case analysis and again can have a substantial impact on whether you qualify as an REP.  

Summary

Qualifying as an REP can be very favorable and result in significant tax savings for taxpayers who not only engage full-time in real estate but also those who supplement their time working in real estate. In recap, to qualify as an REP, you must: 

1. Perform more than 50% of services in real property trades or businesses (the 50% test), and

2. Perform more than 750 hours of service in real property trades or businesses (the 750 hours test), and

3. Materially participate in each rental activity (the material participation test).

Determining whether you qualify under this three-pronged test requires a deeper dive, but the potential tax savings will make it worth your time.  If you are involved in real estate right now and think there is a chance you may qualify, feel free to book a discovery call and let Visibility help you navigate your way to more robust tax savings.