If you’re a taxpayer with income from rental activities or other real estate investments, it’s important to understand whether the IRS considers you a real estate professional. This consideration impacts the tax treatment of any rental income or losses and, consequently, may result in significant tax savings.
Do You Qualify as a Real Estate Professional?
In general, rental activity, whether it’s long-term or short-term, like an Airbnb or Vrbo, is considered passive and any rental losses you incur can only be offset against passive income. Thus, in a given tax year, you may have income from non-passive sources, like a W-2, 1099, or Schedule C earnings, but the rental loss can’t be used to reduce the resulting taxes. Instead, it will be carried forward until you either dispose of the activity or earn passive income.
Activities that Qualify You as a Real Estate Professional
According to guidance issued by the IRS, if you qualify as a materially participating real estate professional, your rental income or loss is considered ordinary rather than passive income. Active or material participation allows you to offset potential rental losses against other ordinary income sources, such as earned wages or Schedule C earnings. This can substantially lower your tax liability and further help during profitable years, as your rental income would not be subject to the 3.8% net investment income tax.
To qualify as a real estate professional, a taxpayer must meet both of the following criteria:
- Taxpayers perform more than 50% of services in real property trades or businesses in which they materially participate.
- Taxpayers perform more than 750 hours of service in real property trades or businesses in which they materially participate.
Real property trades or businesses include real property development, re-development, construction, reconstruction, acquisition, rental, operation, management leasing or brokerage trade or businesses. The 50% test ultimately means that the taxpayer needs to spend the majority of their business hours engaged in real estate activities.
Do You Need to be a Real Estate Agent or Realtor?
You don’t need a particular certification or to be an agent or realtor to qualify as a real estate professional. For instance, a taxpayer can have a Schedule C business involving the purchasing of real property and subsequent renovation and resale along with a separate rental property.
As long as the taxpayer spends the majority of their time on real estate-related business, which includes time spent on their Schedule C business, and they reach the 750-hour test on all of their real estate activities, they qualify as a real estate professional. Another caveat to note is that personal services performed as an employee don’t count towards the 750 hours test unless you are at least a 5% owner of the employer, i.e., working as a real estate agent while owning 5% or more of the real estate sales office.
Establishing Material Participation
Once you’ve established that you’re a real estate professional, the last hurdle is to establish that you materially participate in managing your rental properties. To establish material participation, you must meet one of the seven criteria of material participation, which are detailed in the blog linked above. Participation in managing the activity doesn’t count in determining whether you materially participated under this test if one or more of the following applies:
- Someone other than yourself received compensation for managing the activity or
- Any individual spent more hours during the tax year managing the activity than you did, regardless of whether the individual was compensated for the management services
Additionally, if you happen to be a real estate salesperson, you cannot group your hours worked as a salesperson with your rental real estate activities for the purposes of determining material participation.
Anders has experienced tax advisors on our real estate team that can help investors navigate complex tax challenges that come with the industry. To learn more about how our advisors can alleviate your tax burden with careful planning and the associated fees, contact Anders below.
