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How Real Estate Investors can reduce their tax liability with the Real Estate Professional Status

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What is the Real Estate Professional Status?

One of the most powerful tax strategies for real estate investors is the Real Estate Professional Status.

The Real Estate Professional (REP) status is a designation that allows taxpayers who participate in a real property trade or businesses to use their rental property losses to offset income from their W-2 job and/or business income.  Without the REP, you can only use loses from your rentals to offset gains from your rentals and any unused loses get carried over to future years.

How do you qualify as a REP?

To qualify as a real estate professional, you must spend more than 750 hours and spend more than 50% of your time in a real estate trade or business.

The 750 hour test is pretty straight forward.  However the more than 50% test is a little tricky.  So I will use an example to illustrate it.  Let’s say a taxpayer works part time as a Lawyer totaling 1000 hour per year.  In order to meet the more than 50%, test the taxpayer must spend 1001 or more hours in a real property trade or business.

What is a Real Estate Trade or Business

The IRS gives several examples of real estate trades or businesses.  Some common ones are real property development, construction, rental, property management, and brokerage.

The Last Hurdle

Once you qualify as a REP, the last hurdle to be able to use your rental loses is that you must materially participate in your rentals.

The IRS has 7 tests in order to meet the definition of material participation.  The most commonly used tests are:

  1. Activity that constitutes substantially all of the participation. 
  2. 100 hours and more than anyone else
  3. 500 hours

Substantially All Test Example

Let’s say you own a 10 unit apartment building.  You must do substantially all of the work on the property. You do all of the maintenance and repairs.  You show the apartments when they are empty, prepare leases, and you do the collections work.

100 hour Test Example

You own rental properties.  You spend on average 2 hours per week on your rental properties and nobody else spends more than that on average to help you manage and maintain the properties.

500 hour Test Example

You have a significant rental portfolio that you spend more 10 hours per week on.  In this case it does not matter how much time other people devote to your portfolio.

Final thoughts

The REP Status is not for the faint of heart.  Electing REP on your tax return can increase your chances of being audited by the IRS.  So the last point I will make that if this is an area that you would like to pursue you need to put the work into documenting your time.  In most IRS tax court cases that I have read, the taxpayer loses the case if they don’t have detailed time records of their real estate activities or if they create the records after the fact. 

If you spend most of your time in real estate activities, the real estate professional status can help you greatly reduce your taxes.  But this is not a strategy to try to do on your own, talk to your CPA to guide you.

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