The Real Estate Professional vs IRS


This post is in: Blog, Real Estate
5 Comments

real-estate-professional-vs-irsThe hottest tax topic is still the real estate professional tax deduction versus the IRS. Let’s start off with what that is and why it’s important.

You may have heard that the three benefits of real estate investing over any other type of investing are:

  1. Cash flow,
  2. Possibility of appreciation, and
  3. Tax breaks.

Unfortunately, if you buy too high or in a market with high prices and relatively lower rents, you won’t have positive cash flow. This was especially true in some of the really overheated markets like southern California in the pre-2007 crash years. So, cash flow wasn’t a viable option for a lot of people. Some people still have that issue with their real estate.

Hopefully, your property will appreciate. That’s true for any asset you purchase. So, real estate isn’t really different from any other asset in that regard.

The promised tax breaks come about because you thought you could offset real estate losses against other income. In fact, there were a lot of famous real estate seminar promoters who told you could. And, you can. But only in the right circumstances.

for-rent-signIf you have a real estate loss, you can take that up to $25,000 of loss against other income provided your adjusted gross income (AGI) is less than $100,000. If your income is over $150,000, you can’t take any of the loss. The amount allowed for deduction phases out when your income is between $100,000 – $150,000.

There is an exception and this is where the controversy with the IRS comes in. If you are a qualified real estate professional, you can take an unlimited amount of real estate losses, no matter how much other income you have.

There are three tests to take a qualified real estate professional deduction. Please note: There are THREE tests. It doesn’t matter if you read something that was 10 years old and only talked about one of the tests. Today, here and now, you must pass 3 tests.

3-tests#1: You or your spouse (if you file married filing jointly) must qualify as a real estate professional. That means you spend at least 750 hours per year performing real estate activities. If you have another job or business, you must spend more time in real estate activities.

Recently I saw a mistake that someone had made by thinking all they needed to do to be a real estate professional in the eyes of the IRS was get a real estate license. They didn’t think the other two tests were important or even realize that just getting a license will do it. You can only pass this test if you spend at least 750 hours per year and have more hours doing this than any other job or business.

Remember that these hours are either you or your spouse. You can’t combine the hours.

#2: You must have material participation for your property. There is so much confusion about what this means. It is not active participation. It’s material participation with a very specific definition in the IRS code. Some of the things that would qualify are:

  1. You and your spouse (yes, you can combine hours) have 500 hours of material participation in the property,
  2. You and your spouse have at least 100 hours and more than anyone else,
  3. You had substantially all of the hours spent working on this property (including non-owners), and
  4. Four other possibilities.

You must keep records of the hours you spent on the property. The IRS will assume you don’t participate if you have a property manager, so be prepared to prove you were involved and in what way.

#3: Each property must qualify by itself. They each have to qualify unless you make an election to aggregate the properties. If you make that election, you only have to meet the test once. There is a possible problem, though. If you sell one of the aggregated properties at a loss, you can not take that loss against other income.

The Real Estate Professional tax deduction is a tough one to prove if you try to skip the steps or gloss over the details. You need to have an experienced tax pro alongside you.


5 Comments

  1. Hanna says:

    Thanks for the nice blog Diane!
    As for the election, do all the property have to be in the same state? I have 4 in TX, 1 in TN and 1 in IL so I don’t know whether I can combine them…
    And what are the examples of material participation if you have a property manager..can this be looking for the vendors, researching market rent before renewing the lease, checking the bank account, reviewing reports from the property manager etc?

    Thank you and sorry for the long questions.

  2. Diane Kennedy says:

    Bill,

    I’m assuming she is a 1099 Independent Contractor in her RE agent position. If that’s the case, those hours do indeed count. She’d need to have some kind of log, calendar or journal that shows the amount of hours she actually spends doing it.

    The time she spends monitoring your properties counts. Remember she also needs to have material participation in the properties.

  3. Bill says:

    Thanks so much for your expertise. Here is my specific question:

    My wife is a RE agent, has no other job except as a part-time employee (4 hours a week) of my business. My business has no other employees except my children. Since her acquisition of her license (2 years ago) her job description is to track the bank accounts of 2 strip malls I hold within my 401K. Would these hours count towards the 750 hours required of her and towards the 500 hours as well? We have not filed for RE Professional up to this point. Thanks for your time.

  4. Diane Kennedy says:

    Alan, these are two separate tests.

    #1: Real estate professional. This is the 750 hour and more than any other trade or business test. Only one person can use their hours to qualify.

    #2: Material participation. In this case, you CAN combine hours to qualify.

  5. Alan says:

    That is still very confusing. The IRS wants you to do it wrong, so they can catch you and show that there jobs are important.

    Count to 10. okay. It is what it is.

    I am confused:
    In #1 it says you can not combine hours, 750 by one person. Yet in #2.1 it says “you and your spouse (yes, you can combine hours) have 500 hours”

    How do these two relate?

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