Metro Accounting & Taxes, CPA is dedicated to ensuring the accounting success of all realtors and real estate investors. We have created this guide to help you understand the advantages of qualifying as a real estate professional and the tax benefits that can be derived from doing so.
Qualifying as a real estate professional can have significant tax implications with respect to both the passive activity loss rules and the net investment income tax (NIIT). Satisfying the real estate professional requirements enables a taxpayer to avoid the passive activity rule that ordinarily applies to a subset of the qualifying real estate professional’s activities – rental activities.
Instead, real estate professional’s rental activities are analyzed with respect to the general passive activity loss rules. This would sometimes allow the real estate professional to utilize current year operating losses from the rental activities against other types of income rather than only being able to utilize them against passive income. In addition, rental income recognized by a qualifying real estate professional who materially participates in the rental activities is not subject to the 3.8 percent net investment income tax.
It should be noted that simply working in real estate is not sufficient to qualify as a real estate professional. Under the applicable rules a taxpayer must pass two quantitative tests to be considered a qualified real estate professional:
1. It is required the taxpayer spend more than 50 percent of his or her personal service time in real property trade or business activities in which the taxpayer materially participates.
2. The taxpayer is also required to spend more than 750 hours in real property trade or business activities in which the taxpayer materially participates.
If a joint return is being filed, only one spouse is required to meet the above requirements. These requirements must be met annually. As a result, qualification in a prior year does not guarantee the same treatment in a subsequent year. Similarly, failing to meet the test in a given year does not preclude the individual from satisfying the requirements the following year.
Test # 1 – 50 percent personal service time and material participation
The first test essentially requires that the individual devote over 50 percent of his or her working hours to real estate activities in which he or she materially participates. As such, a person with a full-time job in an unrelated field will almost certainly struggle to satisfy this first prong of the requirement. Note that in order for a taxpayer’s time to count toward the 50 percent threshold, the taxpayer must first materially participate in the activity. Thus, it is important to first assess whether a taxpayer materially participates in a real property trade or business, and then compare the hours spent in all such activities to the total personal service time worked in all activities to see whether the first test has been satisfied.
Test # 2 – Spend > 750 hours in real property trade or business
The second test that must be met is the 750 hour test. The taxpayer carries the burden of proof to substantiate that he or she spends at least 750 hours per year performing services for these activities. It is imperative to keep accurate and detailed records that track specific tasks, meetings, responsibilities, locations, etc. This is very important as the IRS has recently been successful in court cases where taxpayers failed to provide adequate documentation to support their time spent in qualifying real estate activities.
Rental activity aggregation election
A taxpayer who satisfies these two tests, and therefore is a qualified real estate professional, is only part way there. Being a qualified real estate professional simply means that the taxpayer is not subject to the passive rule with respect to his or her rental real estate activities. But the taxpayer must still materially participate in his or her rental activities to avoid passive treatment with respect to those activities.
This determination is normally made on a property-by-property basis. In situations where the taxpayer owns many rental properties, it would ordinarily be difficult to meet the material participation thresholds for any one activity by itself. Fortunately, there is a potential solution to this problem. If a qualifying real estate professional holds a direct or indirect interest in multiple rental properties, he or she should consider making an election to aggregate the hours spent in all of rental activities in order to meet the material participation thresholds. It is important to note that hours devoted to a rental property held indirectly through a real estate investment trust (REIT) do not necessarily count for purposes of the hour tests. In other words, a taxpayer who invests in rental assets through both REIT and non-REIT structures may need to be cognizant of the hours spent on the non-REIT assets.
Seek professional advice
With recent legislation, court decisions, and increased IRS audit activity, the real estate professional rules have taken on renewed focus. Please discuss with your tax advisor the applicability of these specific rules to your situation to determine if you can qualify for and benefit from this designation.
To take advantage of the real estate professional classification, call 470-240-5143 or visit Metro Accounting & Taxes, today. Our CPA will provide you with the support necessary to maintain long term financial stability.
User | 5/10/2017