A Comprehensive Guide to Real Estate Professional Designation
Are you a real estate investor looking to optimize your tax strategies? The real estate professional status designation might just be the game-changer you've been seeking. By acquiring this status, you can claim certain expenses on your taxes that were previously unavailable. But what exactly is the real estate professional IRS designation? And how can you qualify for it? Let's dive into the details and uncover everything you need to know about this designation.
Real Estate Professional Definition: Unlocking the Criteria
To qualify for the real estate professional status, you must meet specific criteria set by the IRS. According to the IRS, you will be eligible for this designation if you meet the following conditions:
- More than half of the personal services you performed in all trades or businesses during the tax year were related to real property trades or businesses in which you materially participated.
- You conducted more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Essentially, the real estate professional IRS designation signifies that you operate a real estate business and actively work in that business on a regular basis.
Demystifying "Real Property Trade or Business"
The rules regarding what qualifies as a real estate business can be somewhat vague. As per section 469(c)(7)(C) of the IRS code, a real property trade or business encompasses various activities, including:
- Real property development
- Redevelopment
- Construction
- Reconstruction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage trade or business
Property management businesses fall under the "management" category, indicating that property managers are indeed participating in a real property trade or business. However, it's crucial to note that not all hours count toward the two tests required for this designation. Tasks such as education and research hours or infrequent travel time may not be considered. The burden of proof also lies with you as the investor to demonstrate that you qualify in case of a tax audit.
Pro Tip: To mitigate the risk of an audit, it's advisable to track your time meticulously using a spreadsheet, calendar, or time tracking app. Additionally, organizing your receipts in one place, such as using a filing system or an online tool like Hemlane, can streamline your processes and ensure your records are well-managed.
Real Estate Professional Tax Deductions: Unlocking the Benefits
Qualifying as a real estate professional can yield substantial tax benefits. When you meet the requirements and materially participate in your rental activities, your rentals are considered "non-passive." This distinction allows your rental losses to offset any type of income without limitations, unlike passive losses that can only offset passive income.
For instance, let's say you have a net income of $150,000 from managing your properties and incur $20,000 in passive losses due to depreciation. If these losses are passive, you cannot use them to offset your net income. However, as a real estate professional who materially participates in your rentals, these losses become non-passive. Thus, the $20,000 of non-passive losses can reduce your taxable income to $130,000, potentially saving you around $6,000 in taxes.
Property managers and self-managed property owners have an advantage in qualifying as real estate professionals. While landlords who hire property managers may struggle to demonstrate material participation in their rental properties, self-managed properties allow investors to log hours toward the 750-hour test and show active involvement in the operations.
Best Practices for Real Estate Professional Designation
To make the most of the real estate professional designation, consider the following best practices:
- Marriage or Common Law: If you have a spouse, obtaining the designation becomes easier as only one person needs to qualify. Couples can claim all the real estate deductions associated with the real estate professional designation, even if one partner continues to work a full-time job.
- Material Participation: Material participation means actively being involved in the day-to-day management of your real estate business. Ensuring you play a role in aspects like maintenance, leasing, and acquisition is crucial. Property management software can help demonstrate active involvement in your operations.
- Passive Investor: Passive investing or participating in crowdfunding does not qualify for the real estate professional designation. To qualify, you need to materially participate in the day-to-day operations of an actual real estate business.
- LLCs: While limited liability companies (LLCs) provide liability and asset protection, they do not impact your status or qualification as a real estate professional. Whether your properties are held in an LLC or not, you must still demonstrate material contribution to the management and operations.
- Year-by-Year: The real estate professional designation is not a one-time achievement. You need to prove each year that you meet the criteria mentioned above. Qualifying in a previous year does not guarantee qualification in subsequent years.
Maximizing the Benefits with Real Estate Professional Status
For those with full-time jobs, attaining the real estate professional status can be a challenge. You must materially participate in the operations for over 750 hours and spend more than half of your time on these activities. However, real estate investors can still utilize local management support while demonstrating material contribution. As long as you own 5% or more of a real estate business and actively perform duties in various categories, you can qualify for the real estate professional status. To simplify self-management, technological advancements like Hemlane offer innovative software, access to leasing agents, and a 24/7 repair center. By leveraging such tools, you can achieve the professional status and optimize your tax strategies, even if you are remotely investing.