If you own rental real estate, there are three different ways to treat your rental losses depending on your status. One of these is “Real Estate Professional.”
First, let’s dispense with one myth: Real Estate Professional status does not mean you have to hold a real estate license. Rather, it is a designation you obtain by meeting certain specific requirements. The first requirement is that you spend more than 750 hours in real property trades or businesses in which you materially participate. The second requirement is that you spend more time in your real property trades or businesses than in ALL OTHER trades or businesses combined. Time spent as an employee in real property activities is counted only if you are a more than a 5% owner in that business. If you qualify as a real estate professional you can deduct all your current year rental real estate losses against other income without limitations.
What is a real property trade or business? A real property trade or business is defined as ANY real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
You have to meet the above requirements each year. So, you could be a real estate professional one year but not the next. Only one spouse needs to meet the requirements in order for a married couple to take advantage of the benefits provided by the real estate professional status.
The 750 hours test must be met for each activity. So for example, say you have three rental properties. The general rule is that you have to perform at least 750 hours on activities related to EACH of those three properties. Fortunately, there is an exception to this rule. If you make the election to aggregate all of your rental real estate activities into one activity, you only have to meet the 750 hours requirement once for the tax year.
What types of activities qualify as real estate professional activities? Activities such as:
– Searching for possible rental properties
– Attending real estate seminars or reading real estate books
– Meeting with real estate agents and viewing properties
– Meeting with mortgage brokers with regards to getting loans on properties
– Travel time to and from the seminars and your property searches
– Preparing your bookkeeping and tax information for your rental properties
– Time spend buying or selling properties (i.e. signing the closing documents)
– Studying and reviewing financial reports (Investor-type)
– Preparing summaries or analyses for personal use (Investor-type)
– Monitoring finances or operation in a non-managerial capacity (Investor-type)
An important note to the investor-type activities mentioned above is that these activities can only be counted towards real estate professional time if you are involved in the day-to-day operations or management of the activity for which you perform those tasks. Essentially, this means that if you have an independent property manager and your only real estate business is your rental properties, you probably will not qualify as a real estate professional.
The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means. Documentation required includes the identification of services performed over a period of time and the approximate number of hours spent performing such services during such period, based on appointment books, calendars, or narrative statements. Documentation is the key when claiming real estate professional status. Most taxpayers who lose in the tax courts lose because of poor documentation. Although documentation through a reasonable means is pretty vague, the tax regulations are clear that post-event “ballpark guesstimates” are not permitted and will not hold up in the tax courts.
Real Estate Professional status is such an important designation for a high-income real estate investor that we strongly recommend you spend time with your Tax Coach to determine if and how you can become a Real Estate Professional and deduct all of your rental losses.
Are you ready to permanently reduce your taxes?
Tom Wheelwright is not only the founder and CEO of Provision, but he is the creative force behind Provision Wealth Strategists. In addition to his management responsibilities, Tom likes to coach clients on wealth, business, and tax strategies. Along with his frequent seminars on such strategies, Tom is an adjunct professor in the Masters of Tax program at Arizona State University. The Atelier