Do you own and manage real estate properties as your primary occupation? If so, you may qualify for real estate professional status (REPS). Real estate professional status is a tax designation with the potential to reduce the tax liability of real estate professionals significantly. To qualify for and maintain real estate professional status, individuals must meet specific requirements set forth by the IRS. So, what are the benefits of REPS, and do you qualify for this designation? Let’s break it down.
What are the tax benefits of real estate professional status?
Individuals with REP status are exempt from passive activity loss rules typically applied to rental properties. Passive activity loss rules dictate that passive losses cannot be used to reduce an individual’s earned (ordinary) income for tax purposes. Under this regulation, losses incurred from passive activities can only be used to offset passive income, not active income. Rental activities are normally subject to passive activity loss rules because they are considered “passive activities” by the IRS, even if the owner is substantially involved in the operation of the property. However, the IRS makes an exception for individuals with real estate professional status. Rental activities are not considered passive for real estate professionals who materially participate in real estate activities. This means that individuals with REP status can use losses incurred from rental activities to reduce their overall taxable income.
How do you qualify for real estate professional status?
The IRS defines a real property trade or business as the following: a trade or business that develops (or redevelops), constructs (or reconstructs), acquires, converts, rents, leases, operates, manages, or brokers real property. To qualify for REPS, you must:
- Spend more than 50 percent of your time materially participating in real property trades or businesses.
- Perform more than 750 hours of service in real property trades or businesses in which you materially participate.
Please note, there are also other requirements that are looked at by tax courts. There have been recent cases challenging taxpayers’ qualifications for real estate professional status; as such, it is crucial to carefully review and document your real estate professional qualifications.
The most important component of REPS qualifications is the issue of material participation. But what does it mean to materially participate? Material participation requires active involvement in the operation of the activities. To qualify for REPS, an individual must meet at least one of the specific material participation requirements outlined by the IRS. Speak with your financial advisor to determine if you meet any of these requirements. Some examples of material participation include: showing property to potential renters, processing tenant applications, performing maintenance and repairs of the property, supervising a property manager, purchasing supplies, and communicating with renters. Activities such as research, education, and investor activities typically do not count as material participation.
To qualify for and maintain REP status, real estate professionals must maintain contemporaneous records of work hours and activities. The chances of being audited by the IRS increase when you attain REP status, and you will be responsible for providing evidence of qualification. If audited, you must be able to prove material participation using evidence such as time logs, work calendars, appointment books, emails, records of meetings, or receipts.
What’s next?
Real estate professional status can offer significant benefits to people who own and operate rental properties. If you are interested in applying for this tax designation, it’s important to speak with a tax professional who can help you review the qualifications and get the most out of potential tax benefits. RBT CPAs is here to assist you. Our experts can help you minimize your tax liabilities and maximize deductions with our strategic tax planning tailored to the unique complexities of the real estate industry. And as always, we are here to support all of your other accounting, tax, audit, and advisory needs. Give us a call today to learn more.