The IRS has specific rules that govern real estate professionals, particularly when it comes to deducting passive losses. These rules fall under IRS Section 469, which details Passive Activity Loss (PAL) Rules. Understanding these guidelines can help real estate professionals maximize their tax benefits.
What is IRS Section 469?
IRS Section 469 was established to prevent taxpayers from using passive losses to offset other types of income, such as wages or investment earnings. A passive activity generally involves business ventures where the taxpayer doesn’t materially participate or rental activities.
For most people, rental real estate is considered a passive activity. However, by qualifying as a real estate professional, you can take losses from your real estate activities and offset them against your other forms of income, providing potential tax advantages. The ability to deduct losses from real estate activities can be highly valuable for reducing your overall taxable income, but strict rules apply.
How to Qualify as a Real Estate Professional
To qualify as a real estate professional under the IRS rules, you must meet two essential tests during the tax year. These tests ensure that you are heavily involved in real estate activities either for your own properties or in a real property trade or business for others.
1. The Material Participation Requirement
To be considered a real estate professional, you must materially participate in real estate activities. In essence, this means being involved in the operations of real estate businesses on a regular, continuous, and substantial basis. This participation is required across all activities you perform, whether it's managing properties, leasing, or other real estate-related services.
2. Two Key Tests to Qualify as a Real Estate Professional
For IRS purposes, you must meet both of the following tests to qualify:
More than 50% of Your Personal Services in Real Property Businesses: You must spend more than half of your total working time in real property trades or businesses in which you materially participate. This includes time spent on property development, property management, leasing, construction, and brokerage (excluding real estate financing).
The 750-Hour Rule: You must work at least 750 hours during the year in real estate-related trades or businesses where you materially participate. This time can be spread across multiple real estate activities but must be directly tied to property-related work. Additionally, any time spent in activities as an investor (such as reviewing financial reports) does not count toward the 750 hours.
Can Real Estate Activities for Others Count Toward the 750 Hours?
Yes, real estate activities that you perform for others, such as in a job, can count toward the 750-hour requirement. This means that you don’t have to be working solely on your own rental properties to qualify as a real estate professional. However, there are some important considerations based on your employment status:
Working as an Employee
If you are working as a W-2 employee for a real estate company, the time spent in that job will only count toward the 750-hour rule if you own at least 5% of the business. If you don’t meet that 5% ownership test, then the hours worked as an employee won't count toward qualifying as a real estate professional.
Self-Employed or Contractor
If you are self-employed or working as a contractor in real estate (without being a W-2 employee), the hours spent providing services in real property trades or businesses will count toward the 750-hour requirement. This is a great advantage for people working in real estate as independent contractors or those running their own real estate firms.
Exceptions to the Passive Activity Loss Rules
In general, passive activity losses (such as losses from rental real estate) can only be deducted against passive income. However, if you qualify as a real estate professional, you may be able to deduct real estate losses against other types of income. Additionally, there’s an exception for taxpayers who actively participate in rental real estate, allowing them to deduct up to $25,000 in passive losses against non-passive income, subject to income phaseouts.
Conclusion
Becoming a real estate professional under IRS rules can offer significant tax advantages by allowing you to offset losses from your real estate activities against other income. By meeting the material participation requirement and passing the two key tests (spending more than half your working time in real estate and working at least 750 hours in qualifying activities), you can take advantage of this status.
Whether you work on your own properties or for others in a real estate trade or business, understanding the rules around real estate professional status can help you optimize your tax strategy. That's where sebCFO comes in! Real estate investors hire us to help them think through the requirements of becoming a real estate professional and whether it makes sense for their situation.
Contact us today to get started on your path to real estate success!
If you read this far, you must be an action-taking entrepreneur looking to take their business to the next level, which means YOU are our ideal client! Mention this blog post when you contact us and we’ll take $100 off any service for new clients.