Everything You Need to Know About Real Estate Professional Tax Status

by | Aug 22, 2023 | Financial Freedom, Life of Your Dreams, Real Estate Investing 101 | 0 comments

Real estate investments are often referred to as a significant way the wealthy stay that way.

Why is this?

While you may have read about tax benefits, passive income, and how real estate investments are separate from Wall Street, there’s a twist for high income-earning families.

High incomes typically come with high tax liabilities, especially if you don’t know the in’s and out’s of tax law, which few of us do. Even if, as a high-income earner, you’re maxing out your retirement contributions, donating thousands to charity, and being creative about write-offs, it’s likely your income continues to put you in a higher tax bracket.

As your household income increases, tax deductions phase out, leaving you with an ever-increasing tax bill and a lot of frustration. This is tough because as you or your spouse achieve promotions and climb the ranks, you want to be excited, but that looming tax bill dampens the party.

It used to be that high-income earners were generally self-employed and could take advantage of deductions available to business owners. However, these days, high-profile positions like physicians, attorneys, engineers, and tech professionals are increasingly employed in-house by large companies. This shift from being self-employed with your own practice to a W-2 employee means reduced opportunities for tax deductions are available to you.

That is, until you discover the real estate professional status (REPS).

In this article, I’ll share all about what REPS is, how achieving the REPS tax designation can positively impact your tax liability, and why, in this case, it’s beneficial to have one spouse manage the family’s real estate investments full-time while the other focuses on their prestigious career. If you or your spouse is a high-income earner, and you’ve been looking for a way to reduce your tax liabilities even though deductions are phasing out, you’re in the right place!

Note: We are not CPAs or Tax Attorneys. Be sure to get your own qualified advice from a licensed professional. This is our best understanding and inspiration for further research on your part.

 

How Does REPS Help High Income-Earning Families?

Cost segregation studies, accelerated depreciation, and other aspects of real estate can often produce on-paper losses for investors, which result in reduced tax liability (despite having made money). Cool, right?

Well, suppose you’re a married couple filing jointly, and you make over $150,000. In that case, you can’t use passive real estate losses to reduce your taxable income because there are no “special allowances” for these high-income families, according to the IRS. Those suspended passive losses aren’t lost though…they carry forward until you have a year of passive gains from your real estate investments, since passive losses can’t normally offset ordinary income like that from a W-2 job.

(or can it?)

Now suppose one of the spouses in this theoretical $150K+ earning family designates themselves as a real estate professional and meets the qualifications – then the entire equation flips!

 

As an example, let’s look at Mark and Lani’s family. Mark is an in-house attorney for a technology company, and Lani manages the household, gets their fourteen-year-old to soccer practice and school events, and oversees the couple’s investment strategy. Mark makes $250,000 plus bonuses, while Lani manages the day-to-day activities of their real estate investments, which has quickly turned into her full-time job.


Even though her properties have positive
cash flow, Lani generated $150,000 in losses from her real estate business last year. Here’s where it gets interesting…

Suppose the couple has designated Lani as qualifying for real estate professional tax status. In that case, they can deduct all $150,000 in (passive) losses from Mark’s $250,000 ordinary income, leaving only $100,000 reflected as taxable income and dropping them into a lower tax bracket.


However, if Lani doesn’t qualify for or doesn’t designate as a REPS, the couple is taxed on all $250,000 of income, approximately doubling the amount owed in taxes. 


Without a REPS designation, Lani’s $150,000 in passive losses must be carried forward until they have passive gains they can apply them against. Meanwhile, the couple is taxed on Mark’s total income, likely for several years.

 

If you’re making all the right moves – earning, donating, contributing to retirement, and investing in real estate, why pay more in taxes than you should? The REPS designation helps high income-earning families reduce their tax liability by allowing their real estate deductions to count when they need them.

Related article: Cash Flow in a Real Estate Syndication—Where Does it Come From?

What is Real Estate Professional Status?

REPS allows couples to divide and conquer – one high income-earning spouse gets to lean into their profession while the other claims the REPS designation and assumes responsibility for managing the day-to-day activities of active real estate investments, qualifying the couple for significant tax benefits.

Amazing, right? Another cool tidbit about REPS is that there’s no test to pass, formal certification to achieve, or degree you need to earn.

Anyone can claim real estate professional status (REPS), as long as—

  1. More than half the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.

    2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you
    materially participated.

This is, of course, lined out in detail in IRS Publication 925, but basically, real estate has to be one person’s primary job. There’s not much time in a year beyond the 750 hours required for anything besides maybe a part-time job.

 

How to Achieve REPS

Now that you can see the benefit of one spouse being the designated real estate professional in the family, you’re probably thinking, “Why have I never heard of this?,” or “How come I’m just finding out about this?”…and I couldn’t agree with you more!

Now, you need a plan to put this into action in your own family.

First, you’ll need to decide which spouse will become the real estate professional. You’ve got to divide and conquer if you really want to do this. Neither spouse can work full time plus manage real estate full time; the IRS won’t recognize it.

For some families, this is easy because one spouse is already the primary breadwinner and the other is a homemaker. But in other families where both spouses are working, the choice may be a little more challenging.

Beyond each spouse’s current income, consider things like career trajectory, passion for career, passion for real estate, other assumed roles as the real estate professional (child care/homemaker?), and each spouse’s ability to single-handedly organize and execute ideas.

Consider the trust you have in each other and this renewed commitment each person is making to execute their role to the best of their ability.

No matter which spouse chooses to become the real estate professional, they need to be serious about treating real estate investment management activities as a business.

Discuss REPS and your decision to designate yourself as such with your CPA so that you can coordinate timing, real estate purchases, tax filings, and more. From there, set aside funds to invest, start shopping for your first investment properties, and track your real estate business activities closely. Or maybe you already have properties, and you’re just now understanding you could be eligible for REPS. 

One thing to note is that passive investments in syndications do not qualify as material participation unless you’re helping actively manage the property (typically as a general partner). However, as long as you have some properties you do actively manage, you can certainly still invest passively to diversify your portfolio. It won’t help you qualify for REPS, but it may help by providing additional depreciation.

Treat your real estate management endeavors like a business by using business bank accounts (separate from your personal finances), an accounting program, and a separate email address for real estate-related communications. Anything you can do to separate your real estate investment management activities from any personal activities and have a provable trail of your 750 hours spent is a good thing!

 

Making REPS Work for Your Family

Successfully operating real estate investments and achieving REPS status may look different for every family, so let’s look at two different scenarios for clarity:

Scenario 1: Two working spouses, one working full time and leaning into their high-income earning profession, and the other working part-time while materially participating (actively involved) in managing the couple’s real estate investments.

Scenario 2: One working spouse and one homemaker who decides to make managing real estate investments their primary job.

In each scenario, the spouse managing real estate needs to commit to (and be able to prove) their material participation in the day-to-day decisions regarding their real estate properties, accumulating 750 hours or more of tracked time and activities over the taxable year.

For most, it would be challenging to spend 750 hours on just a few properties. So if you accumulate several properties quickly, track your time and business activities managing them, and treat your investment properties as a business, you’re more likely to attain all the documentation required to claim REPS.

Investment management activities that add up to your 750 hours per year may mean establishing business-like formalities and systems, deciding when to raise rents, renew leases, buy, sell, renovate, and more. Approach every day intending to maximize profit while simultaneously improving your tenants’ experience, tracking your time and activities (a Google Calendar is an excellent tool for this!), and coordinating with contractors toward successful renovations, and your investment business and REPS status will be booming in no time!

Usually, the 750-hour requirement is per real estate property, but we’ve been told by a CPA that you can combine all of your real estate management activities from several properties into one by including the following language in your tax returns:

Under IRC Regulation 1.469-9(g)(3), the taxpayer hereby states that they are a qualifying real estate professional under Code Sec. 469(c)(7), and elect under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.

That phrase “taxpayer hereby states that they are a qualifying real estate professional” is critical.

If one spouse (it doesn’t matter which one) can consistently hit these requirements, coordinate with tax professionals, and find joy in managing real estate investment assets for the family, REPS can be a huge advantage!

 

Is Real Estate Professional Status for You or Your Spouse?

If you’re part of a married-filing-jointly relationship and have an income over $150,000, you may have been feeling increasingly frustrated by your high tax liability. In fact, it’s highly likely that you’re thinking about investing or you’re already invested in real estate because of the tax benefits, even if you don’t really know how to use them yet.

However, if you want to apply your on-paper losses to your household’s active (ordinary) income, achieving real estate professional status may be the answer. Otherwise, you may be stuck carrying passive losses for years to come.

Remember, we are NOT CPAs or Tax Attorneys, so take the things you’ve learned here as inspiration for more research, open discussion with your spouse and tax advisor, and food for thought as you further examine the most efficient way to move toward your lifestyle and investment goals.

Further reading: Tax Strategies for Real Estate Investors