Being a real estate professional in the eyes of the IRS offers several benefits, particularly in terms of tax advantages. One of the primary benefits is the ability to deduct losses from real estate activities against other types of income, such as W-2 income or 1099 non-employee compensation. This can significantly reduce your overall tax liability.

The IRS generally presumes all rental activities are passive, which means that rental losses can only offset passive income. As a result, net losses will be suspended and carried forward until you have other passive income, or you sell the property. Qualifying as a real estate professional changes the nature of the rental activities from passive to nonpassive, allowing you to deduct losses in the current year. Lower taxes can help with increased cash flow allowing for additional real estate investments.

Additionally, if you have overall positive net income from rental activities and qualify as a real estate professional, the income is not subject to the additional 3.8% Net Investment Income Tax (NIIT) which applies to passive income.

But do you qualify as a real estate professional? To be eligible, you must pass three tests:

More Than 50% Test

More than half of your time working during the tax year must be in real property trades or businesses in which you materially participate.

The IRS considers the following as real property trades or businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, and leasing.

You must own at least 5% of the business to qualify, so working as a W-2 employee for someone else does not count.

750-Hour Test

You must perform more than 750 hours of services in these real property trades or businesses during the year.

Material Participation Test

You must materially participate in each real property trade or business. You are considered to participate materially if you meet just one of the following criteria:

  • Work more than 500 hours in the activity.
  • Do substantially all the work in the activity. This test can be difficult to meet if you have a property manager.
  • Work more than 100 hours in the activity, with no one else working more than you.
  • You materially participated in the activity for any five (whether or not consecutive) of the ten immediately preceding tax years.

Note that these tests are evaluated on an annual basis, so you may qualify one year and not the next. A married couple can count the time of both spouses to meet the material participation test, but not the More Than 50% Test or the 750-Hour Test.

If you have multiple rental properties, you can elect to treat all interests in rental real estate as a single activity. This election simplifies meeting the material participation requirement and can be made on your original tax return.

The IRS scrutinizes claims of real estate professional status closely. It is important to keep accurate and detailed records of your hours and activities, such as calendars and receipts to substantiate material participation.

Please reach out to your KT Tax Advisor if you think this may apply to your tax situation.