By Cristy Andrews and Reed King
If you spend significant time working in the real estate industry, does the IRS treat you as a “real estate professional”? And why does that matter?
Rental real estate is notorious for generating tax losses—often driven by depreciation. For many taxpayers, however, those losses are limited by passive activity loss rules. Passive loss limitations generally carry forward and may be used only to the extent you have passive income, or in the year you dispose of the property in a taxable sale.
That’s where the real estate professional tax designation can make a difference. If you qualify—and you materially participate in the rental activity—certain rental losses may be treated as nonpassive, allowing them to offset salary or business income rather than being deferred. In addition, qualifying income from your real estate activities may be excluded from the 3.8% net investment income tax (NIIT) in some circumstances.
The benefits can be meaningful, but the IRS applies this designation narrowly. Whether you qualify depends on how you spend your time, how your services are performed (and through which entities), and whether your involvement is documented well enough to support the position on audit.
How Your Time Is Allocated
To qualify for real estate professional tax status, you must meet both of the following criteria:
- More than half of the personal services you perform during the year are performed in real property trades or businesses in which you “materially participate.”
- You perform more than 750 hours of services during the year in those real property trades or businesses.
If you meet the criteria above, you then must overcome one more hurdle. You must meet one of the seven material participation tests, outlined by the IRS. For example, you own a successful real estate construction business that results in you meeting the criteria to be classified as 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.
How Your Services Are Performed
Hours worked as an employee generally don’t count unless you own more than 5% of the employer. If you hold ownership interests in real estate but provide your services through a management company in which you have no ownership, that structure can prevent you from qualifying. The IRS focuses on how services are performed and through which entities. Effort and responsibility don’t change the calculation.
Applying This to Your Facts
Determining whether the real estate professional tax status applies to you requires a fact-specific review of how your real estate activities operate in practice. A CPA with real estate tax experience can assess your eligibility, identify structural limitations and evaluate whether the potential benefit justifies the added compliance and recordkeeping.
