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Unlocking the Benefits of Real Estate Professional Status

May 30, 2023

Ashley Christie, Emma Steiner

Qualifying as a real estate professional (REP) can prove to be a powerful tax savings tool for taxpayers who dedicate the majority of working hours to a real estate trade or business. The status has the potential to significantly minimize tax burdens by exempting the taxpayer from the traditional passive activity loss rules as well as the net investment income tax.

How Does It Work?

Rental activities are per se passive and subject to the passive activity loss rules in IRC 469. When a taxpayer is not involved in the day-to-day operations of the rental activity, the income resulting from the activity is considered passive income. The passive activity loss rules limit passive losses to the extent the taxpayer has passive income. Since rental activity is considered passive, rental losses could be limited. This is where the exception for real estate professionals comes into play.

A taxpayer can qualify as an REP if they satisfy the following:

  • The individual must perform more than half of personal services in real property trades or businesses in which the taxpayer materially participates. It is important to keep precise notes of all hours worked in real property trades or businesses. In the event of an IRS audit, the burden of proof falls on the taxpayer; and
  • The individual must spend at least 750 hours during the tax year participating in real estate trades or businesses in which they materially participate. The taxpayer can elect to aggregate their real property trades or businesses activities in order to meet the 750-hour requirement. In order to aggregate, the activities being grouped must be similar in business, geographic location, or interdependent of each other. However, the regulations state that the taxpayer may use any reasonable method to determine if the activities are eligible to be aggregated.

Material participation is a key component of qualifying as an REP. The taxpayer must “materially participate” in real estate activities. Meaning, they are involved in regular operations or management of properties. In order to meet the material participation test, the taxpayer must satisfy at least one of the following:

  1. The taxpayer participates in the activity for more than 500 hours during the taxable year.
  2. The taxpayer’s participation in the activity for the taxable year is substantially all of the participation in such activity of all individuals.
  3. The taxpayer participates in the activity for more than 100 hours during the taxable year, and no one else works more hours than the taxpayer with respect to that activity.
  4. The activity is a significant participation activity for the taxable year, and the taxpayer’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
  5. The taxpayer materially participated in the activity during five of the last 10 taxable years that immediately precede the taxable year.
  6. The activity is a personal service activity and the taxpayer materially participated in the activity for any three prior taxable years.
  7. Based on facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.

Defining Real Estate Activities

Activities that satisfy the tests above can include real estate development, re-development, construction, acquisition, real estate management, and real estate operation. Unfortunately, researching new investment opportunities or being on call for your tenants does not count as active participation hours for the taxpayer.

Additional Benefits

Another benefit of electing to be an REP is not being subject to net investment income tax (NIIT).  NIIT is a 3.8% tax levied on the taxpayer’s net investment income, including interest, dividends, capital gains, non-qualified annuities, royalty income, and, most importantly, passive rental income. If the taxpayer qualifies as an REP and demonstrates material participation in their business, the rental income earned would be considered nonpassive income and would not be subject to NIIT.

While the benefits of qualifying to be an REP are extensive, it is important to talk with a tax advisor to determine if making the REP election is appropriate and to ensure proper and timely documentation is maintained. To learn more, please contact a KSM advisor or complete this form.

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