Many wealthy individuals have learned the secret of having real estate professional tax status. Being an active real estate investor is one of the best ways to build wealth while paying little to no taxes. In fact, if you do it right, you can earn a lot of money every year and pay no tax.
Most of the tax benefits from real estate investing are only available to those who qualify as a real estate professional. Read more to find out how you can get real estate professional tax status.
Please note that we are not financial advisors or registered investment advisors. We do not give investment advice and encourage you to do your own independent research and seek the assistance of qualified individuals where necessary before making any investment decisions.
What is Real Estate Investing?
Investing in real estate can take many forms.
- Buying residential properties that are rented out to tenants
- Managing multi-family properties such as duplexes or apartment buildings of all sizes
- Owning commercial properties that are leased out for use as office buildings, storage facilities, warehouses, or for other industrial uses by businesses
- Buying and selling raw land
- Developing land or buildings by making significant improvements and reselling the properties
- Buying a fixer upper and reselling the property after significant improvements
- Building new houses or commercial properties and selling those houses to third party purchasers
There are also a number of different ways you can invest in real estate. You can hold real estate directly by accumulating a portfolio of properties over time or buy one large property that will have several tenants.
You can also invest in real estate more passively by pooling your money with other investors and investing through a real estate fund. You can also invest indirectly in real estate through REITs (real estate investment trusts). However, REITs are generally not preferable from a tax perspective.
Why Does it Matter?
Real estate investing is the gold standard for tax planning. If you understand how to invest in real estate, you can build massive amounts of wealth while paying $0 tax. Yes I said $0 tax!
Many of the richest people in the world are real estate investors. Some notable real estate professionals include former President Donald Trump, Robert Kiyosaki, author of Rich Dad, Poor Dad, and Stephen Ross, owner of the Miami Dolphins.
A good wealth building strategy should include at least some investments in real estate.
Tax Benefits from Investing in Real Estate
Many investors prefer investing in real estate because it produces tax-efficient cash flow and the ability to recognize appreciation in the property without paying capital gains tax.
There are also many other non-tax benefits to investing in real estate. Read more here about the non-tax advantages to allocating a portion of your assets to real estate.
You get to deduct expenses associated with managing the property
The properties should generate rental income. That rental income can be offset by expenses associated with maintaining the property. The expenses will reduce your net taxable income. In most cases, rental properties will have a net loss for tax purposes when you factor in the largest expense of all, the depreciation deduction.
Typical expenses for rental properties include utilities, property taxes, insurance, repairs and maintenance and other expenses that you are required to bear as the landlord. Expenses paid by your tenant are not deductible on your return.
Ability to convert vacation travel to tax deductible expenses
If there is a place where you like to travel frequently, consider buying a rental property there. This can help you convert expenses that would have otherwise been non-deductible personal expenses into tax deductions.
Remember that when you take a trip that is for both personal reasons (vacation) and business reasons (managing your rental properties), you must allocate expenses between the two purposes. That means when you visit your property, you need to keep good records and closely track the portion of the time devoted to managing that property and the time spent just having fun.
The king of all tax deductions is the depreciation deduction. The depreciation tax deduction is a deduction for the wear and tear of a capital asset, such as a building. For tax purposes, you are allowed to claim a deduction for the value of the building over a set period of time.
Depreciation deductions are typically quite large and can quite frequently result in you having a net loss for tax purposes. This is great because it means you don’t pay any tax on the rental income you earn from your tenants!
You do not get a deduction for land. This means you will need to allocate the purchase price you paid for the property between the value attributable to the land the building sits on and the value of the building, and any other structures or fixtures on the land. Only the portion attributable to the building and structures will be deductible.
You are also allowed to depreciate capital improvements to the property such as adding a deck or storage shed. The amount of the deduction is computed based on the useful life of the property. You would just take the purchase price attributable to the building plus any capital improvements and divide it by the useful life.
Useful life of rental properties:
Residential Property → 27.5 years
Commercial Property → 39 years
Let’s look at a basic example of how depreciation works.
April pays $750,000 for a condo that she will rent out. The breakdown of the purchase price is $150,000 land and $600,000 building. April will get a depreciation deduction equal to $21,818 ($600,000/27.5 years) each year that can offset any rental income she earns.
Property tax bills commonly show a breakdown between the land vs. building. This can be a good guideline to use as a starting point.
Many also use the 80/20 rule in practice where 80% of the value is assumed to be the building and 20% is assumed to be land. There is no basis behind this split but it might be a good benchmark without any other more concrete data.
Just remember that the IRS can always dispute the allocation you use so make sure there is always a reasonable basis for the breakdown.
You are required to recapture depreciation when you sell the property. However, the maximum rate of tax imposed on depreciation recapture is 25%. This rate is lower than the maximum rate imposed on rental income. So there is still a tax benefit to depreciation deductions even when you factor in depreciation recapture.
The building itself must be depreciated over a longer term (usually 27.5 or 39 years depending on the use of the property). However, there are certain portions of real estate structures that can be depreciated more quickly. Cost segregation allows you to separate out the various components of the property and identify the components with a shorter useful life.
Some common examples that may have a shorter depreciation period include:
- Parking lots
- Some plumbing installations
- Light fixtures
- Landscaping improvements
For larger properties, you may want to pay a professional to prepare the cost segregation study for you. However, if your property is smaller, a DIY approach might be more feasible.
The Tax Cuts and Jobs Act of 2017 provided a great benefit to real estate investors by allowing bonus depreciation for certain improvements to properties. Depreciation deductions get even better when you factor in bonus depreciation.
Bonus depreciation allows you to immediately deduct a large portion of the cost of certain assets. Only assets with a useful life of 20 years or less will be eligible for bonus depreciation. See the discussion above on cost segregation for common examples of assets that may qualify.
The amount of bonus depreciation that may be claimed is 100% of the cost of eligible assets for the first few years and will decrease until 2027 when it will no longer be available.
|TAX YEAR||BONUS DEPRECIATION PERCENTAGE|
|2027 and future years||0%|
Defer capital gains tax on sales of real estate
We already discussed the tax benefits you receive from the cash flow (rental income) earned from real estate investing. However, there are also great tax planning opportunities available when you sell the rental property.
You can defer the capital gains tax on any gains when you sell the property under the IRC Section 1031 like-kind exchange rules provided you are willing to reinvest the proceeds for the sale in a new property. This can allow you to continue to upgrade your real estate portfolio over time by buying new properties of greater value that will kick off higher cash flow without paying tax when you sell the properties.
The basic requirements for a like-kind exchange are:
- The new replacement property must be of equal or greater value than the original property you are selling.
- You must identify the new replacement property to acquire within 45 days of the sale of the original property.
- You must close on the new replacement property within 180 days of the sale of the original property.
The rules for qualifying are strict and can be difficult to do in practice. Therefore, the exchanges are commonly done using a third-party intermediary that can help facilitate the transaction. Make sure you work with a qualified professional or have a detailed understanding of the rules before you try to do a like-kind exchange.
Tax Benefits from Being a Real Estate Professional
Now that we know the many tax benefits that come from investing in real estate, why does it matter if you qualify as a real estate professional? The reason is because of the passive activity rules.
The passive activity rules say you can only deduct losses from passive activities against passive activity income. The losses remain suspended and are carried forward indefinitely until you dispose of the underlying property.
Investments in real estate quite frequently kick off tax losses after you deduct all expenses, interest expense on the debt, and claim depreciation deductions. That means you can have a property that is highly profitable from a cash flow perspective but shows a large tax loss. The IRS doesn’t want people using those losses to offset all other income unless they are engaged in a real estate trade or business.
The passive activity rules do not apply if you qualify as an active real estate professional. That means real estate professionals can claim the tax losses from real estate investments against all other income.
Let’s consider a common fact pattern where the passive activity rules apply.
Jane receives a salary of $250k a year from her employer. Jane also owns rental properties that have a net tax loss of ($300k) a year after taking into account depreciation deductions. If the passive activity rules didn’t apply, Jane would pay no tax because her net taxable income would be an overall loss of ($50,000).
However, unless Jane qualifies as an active real estate professional, the passive activity rules say that she can’t deduct her ($300k) rental losses against her $250k active salary income. That means Jane has taxable income of $250k and will pay a lot of tax on her salary income.
The difference can be staggering. In the example above, we are talking about a difference of over $100k-$125k in taxes a year.
The passive activity rules say you can only deduct losses from passive activities against passive activity income.
Who Qualifies as a Real Estate Professional for Tax Purposes?
There are 3 separate sets of requirements that must be met. These requirements must be satisfied each year and are tested based on the activities of the person who seeks to qualify as a real estate professional. That means any work done by the spouse of the real estate professional does not count.
Keep in mind that the requirements can get complicated and there are many nuances and special rules for certain situations. It is important that you have a good plan in place for making sure you satisfy these requirements each year and maintain good documentation.
750 Hour Time Requirement
Real estate professionals must spend at least 750 hours a year on qualified activities. See below for more discussion on what activities can qualify when counting the 750 hours.
Remember that these requirements must be met each year you wish to qualify as a real estate professional. That means you can be a real estate professional one year but not the next. Time spent also does not carry over to future years. So you must be prepared to spend at least 750 hours each year managing the rental properties.
Material Participation Requirement
In addition to spending at least 750 hours, you must also materially participate in the real estate activities.
There are 7 different tests for material participation. All you need to do is satisfy 1 of these 7 tests to meet this requirement. These are the 7 material participation tests (bolded indicates likely to be relevant for real estate investors):
1.You spend more than 500 hours a year on the activity.
2. The time you spend on the activity constitutes substantially all of the participation in that activity for the year.
3. You spend at least 100 hours on the activity and more time than any other person that year.
4. You spend more than 100 hours on the activity and you spend more than 500 hours when you combine all activities that you spend at least 100 hours a year on.
5. You materially participated in the activity for any 5 years during the past 10 years even if you did not materially participate in the activity during the current year.
6. The activity is a personal service activity and you materially participated in the activity for any 3 years during the past 10 years even if you did not materially participate in the activity during the current year. This would typically not be relevant for real estate investors.
7. Based on all the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis.
As a practical matter, if you spend more than 750 hours a year managing a real estate portfolio, chances are good you will satisfy the material participation requirement. If someone spends 750 hours managing their residential real estate properties, they are going to have easily spent at least 500 hours.
Be careful here if you are involved in different types of real estate activities! For example, a real estate broker may be able to use hours spent showing properties to potential buyers in meeting the 750 hour requirement. However, those hours may not count under the material participation test so make sure you work with a professional who knows these rules.
There can be situations where you meet the 750 hour requirement but not the material participation tests. There may also be times when you need to make the grouping election (discussed further below) to make sure you pass all of the requirements.
More Than 50% of Time Requirement
To qualify, the person must spend more than 50% of their time spent on all activities in which they materially participate on the real estate business. As a practical matter, that means when you add all the time spent on all of your businesses, more than half of that time must be spent on the real estate business.
To show how this could work let’s assume Bob owns an online business, a laundromat, and manages a portfolio of 10 rental properties. Bob spends 400 hours a year on the online business, 550 hours a year on the laundromat, and 800 hours a year on the real estate business.
Bob does not qualify as a real estate professional in this case. Even though Bob spends over 750 hours a year on the real estate properties, Bob is a workaholic and spends a total of 1,750 hours on all of his business activities during the year. Because at least half of that time (875 hours) is not spent on the real estate business, Bob fails the requirements.
What Activities Qualify?
A good approach is to think of your portfolio of properties as a business. Just like any other business, you must be involved in the day-to-day operations of your properties.
You can of course hire employees and contractors to help with the properties. However, you must be viewed as managing those individuals. You can’t simply hand over the reins to someone else and be completely removed from the operations.
These are some examples of the types of activities that should qualify.
- Activities involved with finding new tenants, including marketing and placing advertisements
- Screening new tenants, interviews with prospective tenants, running background checks
- Collecting rent payments from tenants
- Communicating with and handling complaints from tenants
- Preparing, negotiating, and executing leases
- Vetting and communicating with vendors
- Seeking bids for work to be done
- Dealings with insurance policies and claims
- Cleaning properties or maintaining the property grounds
- Making or overseeing repairs and maintenance or improvements
- Purchasing materials and supplies
- Handling eviction of tenants
- Property inspections
- Preparing SOPs for your vendors, contractors, and employees
- Education and research (these hours should be kept to a minimum)
- Travel to the various properties (these hours should be well documented and there must be a business purpose for traveling to the property)
- Time spent acquiring new properties (not including research about new properties)
What Activities Don’t Qualify?
It is also important to understand what activities will not count towards the 750 hour requirement. These are some examples of activities which will not help you qualify as a real estate professional.
- Time spent by the spouse of the real estate professional
- Research about new properties for acquisition
- Travel time spent looking at new potential properties to acquire
- Merely watching third-parties conduct activities such as repairs and maintenance (you must be actively involved in supervising these activities)
- Excessive education and research time
- Excessive travel time that is not for business purposes (you must have a bona fide business reason for traveling to the property for the time to count)
When you are testing whether you meet the material participation tests, each real estate activity is treated separately. That means you would have to spend at least 500 hours, or at least 100 hours and more time than anyone else, on each separate real estate activity. Consider the following example for why this would matter.
Barbara builds 4 residential homes during the year. Barbara sells 2 homes to a purchaser and keeps the other 2 homes as rental properties. Unless a grouping election is made, the time Barbara spends on building the homes she sells and the time spent on the homes she keeps as rental properties may not be aggregated. If a grouping election is made, all of the time Barbara spends on the 4 homes during the year can be counted together.
When determining whether you met the material participation tests, you can make what is called a grouping election. The grouping election allows you to aggregate all of your real estate activities and treat them as one single activity when applying the material participation tests. This can help you avoid having to spend more than 500 hours on each individual property you own or real estate activity.
The grouping election does not include hours spent on short-term rental properties. See below for more discussion on how the rules apply to short-term rental properties.
Except for in certain limited situations, the election is binding for all future tax years that you qualify as a real estate professional. If there is a year where you do not qualify as a real estate professional, the election will have no impact. However, the election will remain in effect for any future years that you do qualify again.
The election can be made by individuals, S Corporations, partnerships, C Corporations, and trusts and estates in some cases.
This is getting more into the complicated areas of the law for real estate professionals. I would make sure at a minimum your CPA or tax attorney understands the group election rules, how to make a grouping election, and the pros and cons of the election.
If you know what you are doing, the grouping election can be a very powerful tool you can use to help you lower your taxes. There is a planning opportunity here that can allow you to fully deduct any losses from a limited partnership interest as a passive investor in a real estate syndication. The opportunities available to a real estate professional are endless when it comes to reducing your taxable income!
Special Rules for Short-Term Rental Properties
When talking about real estate professional tax status, it is important that we make a key distinction. Here, we are talking about properties where you will have a long-term tenant such as someone who signs a year lease and pays you rent each month.
This does not include properties that you list on AirBnB or Vrbo. Those types of rental properties are treated differently and have their own set of rules. Importantly, time spent managing short-term rentals does not count for purposes of meeting the time requirements for being a real estate professional.
That means if you are planning to list the properties for short-term stays rather than have long-term tenants who will sign a lease agreement, the time spent on those properties does not count towards qualifying as a real estate professional. Those activities are treated differently on your tax return and have their own set of rules. There can still be tax benefits from managing short-term rentals; however, those benefits are usually not as good as the tax advantages available to real estate professionals.
Practical Considerations for Real Estate Professionals
Now that we have covered all of the rules around real estate professional tax status, you might be finding yourself a bit unsure of how to get started. Most of us probably don’t want to plunge toilets, build houses, or handle calls in the middle of the night about a flood. So how can you really be a real estate professional?
Here are some good guidelines that are based on my own experience from investing in real estate as well as the experiences of my clients who qualify as real estate professionals.
- If you are a real estate broker or real estate developer, it is likely you will have an easier time meeting the hour requirements.
- You will have to own properties directly. That means you cannot only invest in real estate syndications passively, as an LP or a GP partner, and meet the requirements.
- You will need to own and manage several different properties. A good rule of thumb is that you will likely need to own at least 3 or 4 rental properties at a minimum to qualify unless you are buying larger multi-family properties such as apartment buildings.
- It will likely take you a few years to ramp up. It might be difficult to buy enough properties in one year to meet the time requirements. However, with a good plan in place, you should be able to get there in a few years.
- Finding and training your own staff might be more preferable than using a property management company. When you use a property management company, it is usually hard to meet the time requirements because very little oversight by you is needed or justifiable.
- Treat your real estate properties just like you would a business. Use the same processes and systems to manage your portfolio of properties as you would with any other business. It would be easy for any owner of a business to spend 750 hours a year managing their business, so there is no reason a real estate business should be any different.
Supercharged Tax Planning Opportunities for Real Estate Professionals
The tax benefits from being an active real estate investor are endless. Consider these add-on planning opportunities to supercharge your tax position as a real estate professional.
- Start qualifying and investing in real estate several years before a large exit, such as the sale of a business, so that you can build up losses over time that can be used to offset your gain from your business sale in the future.
- If you are a high earner from salary income or business profits, have your spouse qualify as a real estate professional.
- Invest in real estate both directly and indirectly. You can develop a position that allows you to combine your active real estate activities with your passive investments, such as through real estate investment funds, and deduct all of the losses.
- Buy where you like to travel. Buy a rental property in areas where you frequently travel and you can turn what would otherwise be non-deductible personal expenses into tax deductions.
- Turn a vacation home into a rental property. This will allow you to at least deduct a portion of your expenses. It also turns a liability into an asset and helps cover some of those extra expenses.
- Real estate investing is a great tool for implementing the buy, borrow, die strategy.
Documentation and Tracking Requirements
Documentation is key for real estate professionals! If you are audited, the first question the auditor will ask is for proof that you satisfied the 750 hour requirement.
That means you need to keep excellent records, time logs, or journals that show exactly what you did, how you did it, and how much time was involved. The time noted for an activity must be reasonable. If you say you spent 200 hours fixing a door or reviewing a background check, that isn’t likely to stand up against an audit.
Use good judgment in developing a plan for meeting the 750 hour requirement each year. A good rule of thumb I always tell my clients is to make sure you don’t have too much travel time or learning time each year. IRS agents like to see that you are really involved in the day-to-day management of the properties and not just flying around the world to real estate conferences.
As always, don’t forget to maintain receipts supporting any expenses you claim on your tax return.
Where to Report Rental Properties on Your Tax Return
Real estate professionals are viewed as engaged in a trade or business and the activities are reported on Schedule C. If your real estate business is conducted through an S Corporation or partnership, the activities should be reported on the first page of the Form 1120-S or Form 1065, whichever is applicable.
If you hold your properties through a C Corporation, you should probably re-examine your tax structure. Most of the benefits from real estate investing would be lost if you did not own the properties through a flow-through structure.
If you show net positive taxable income from your combined real estate activities, you may be subject to self-employment tax on the income.
If you do not qualify as a real estate professional, investments in real estate are generally reported on Schedule E.