Determining whether you are a real estate professional or a passive investor can have significant tax implications.
Real estate investment can often lead to significant tax savings due to depreciation and other deductions that are immediately incurred. Individuals classified as real estate professionals can use losses from real estate activities to offset sources of income such as wages, active business income, or portfolio income. However, these losses are treated as passive for individuals who cannot achieve real estate professional status. These passive losses would generally only be able to be used to offset other passive income. They could also be carried forward to future years if they are not able to be used currently.
What are the requirements for investors to be real estate professionals and rid themselves of the tax implications from passive rental and business activities?
There are two main requirements:
- More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
- You must spend more than 750 hours on your real property trades or businesses.
Professionals that work as employees must own at least a 5% share of the employer’s business in order for hours spent working as an employee to count toward the 750 hour requirement.
What can be done to demonstrate that you are a real estate professional?
The IRS has recently taken a closer look at taxpayers’ real estate professional statuses to ensure that individuals are not claiming active losses that they shouldn’t. Maintaining real estate professional status can lead to huge tax benefits, so it’s extremely important to be able to demonstrate compliance if challenged.
There was a recent court case, Pourmirzaie, TC Memo 2018-26, that dealt with this issue. In the case, the taxpayers had their real estate professional status and related deductions denied because they did not have enough evidence to substantiate 750 hours of material participation. It is important to keep a log showing the hours spent managing the properties and a record of what activities were performed. As the IRS has recently been extremely active in challenging real estate professional statuses, it is imperative to maintain documentation to defend your positon and demonstrate that you are eligible to deduct losses from your real estate investments.
Achieving real estate professional status can lead to huge tax savings. If you have losses from real estate investments, you should consider whether you are a real estate professional or if it would be beneficial to fulfill the requirements to be able to utilize those deductions. It is extremely important to keep great records of your time spent to be able to show that you qualify. Every investor’s situation is unique, so please consult with your tax advisor before making any tax planning decisions.
