Once you start buying rental real estate, one of the top strategies we recommend to our clients is to consider the benefits of qualifying as a Real Estate Professional. As many real estate investors quickly discover, rental real estate has the amazing power to potentially provide tax losses/deductions with tax free cash flow, on top of building.
In fact, I encourage all of you to ‘at least’ consider buying one rental this year (in or outside of your retirement account) and determine if it is a good fit for you.
Now I realize rental property is not a perfect fit for everyone. There are a lot of variables…your financial strength, credit worthiness, your temperament and time you have to manage property, and of course, it also depends on the season of your life.
However, although buying real estate is something every investor should consider, being a “real estate professional” ISN’T ultimately for everyone. Don’t feel like this should be the first priority in tax planning when it comes to real estate. This classification only helps WHEN you have multiple rental properties and you make less than $150,000 a year in Adjusted Gross Income.
TIP- As a real estate professional you are able to deduct 100% of your rental depreciation and ‘losses’ against ANY other type of income on the front page of your 1040.
There are three categories the IRS uses to classify real estate investors, each having different pros and cons.
1. The first classification is that of a “Passive Investor”. This is the least beneficial category and only allows a taxpayer the ability to deduct passive losses against passive gains.
2. The second classification is that of an “Active Investor”. This designation allows a taxpayer to deduct an additional $25,000 of losses against ordinary income, however, this deduction phases out completely at the Adjusted Gross Income (AGI) level of $150,000 for a married couple filing jointly and $100,000 for a single individual.
It’s often a surprise to our clients to understand how easily it is to qualify for this classification. A taxpayer must simply be involved in the decision making for the real estate investment, and doesn’t even require the taxpayer to make a special election on their tax return.
3. Third, the “Real Estate Professional” classification allows taxpayers to deduct 100% of all real estate losses against ordinary income. Many clients making this special election on their tax return, and who also have several rental properties can create thousands of dollars in tax deductions resulting in a zero tax liability at the end of the year.
To qualify as a ‘Professional’ for tax purposes, a taxpayer, or their spouse, must meet a two-part test: (1) the taxpayer must spend the majority of his or her time in real property businesses, and (2) the taxpayer must spend 750 hours or more in the real property business and rentals in which her or she materially participates.
The biggest question we are often asked is what occupations qualify as real property businesses. The IRS does not statutorily list which jobs qualify, but if you are working as an entrepreneur in the real estate industry, licensed or not, we want to talk about it.
Finally, it’s important to also ‘materially participate’ in the management of the properties. However, the beauty is that you can actually qualify for material participation under 7 different tests.
Again, as a cautionary note, it is important to realize that qualifying as a Real Estate Professional is not a ‘fit’ for every taxpayer. As a Professional, generally all of your business income will be considered ordinary income subject to self-employment tax. Thus, an S-corporation is almost a must for every Real Estate Professional.
If you are considering ‘checking the box’ on your tax return that you qualify as a Real Estate Professional, make sure to ‘run the numbers’ and see what the actual tax impact may be on your tax return.
Consult with your personal tax consultant to determine if this should be part of your tax plan this year or in years to come.
Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP. For more information visit him at www.markjkohler.com.