In Part 1 of this two-part series, we plunged into how real estate income is taxed. We introduced browsers to the idea of becoming a “real estate professional” and the various tax advantages of doing so. Now, what you’re presumably wondering is how to achieve real estate professional status.
Let’s begin this follow-up piece by affirming that earning the designation is no easy task, especially for those already employed full-time. Nevertheless, those who can (either alone or in partnership with their spouse) will achieve an even greater return on real estate investments given the tax benefits.
How to Achieve Real Estate Professional Status
The IRS has specified guidelines describing what is needed to obtain real estate professional status. It’s more tricky to achieve than one might assume. The IRS uses a two-step method in which investors are obligated to meet both criteria to qualify:
1. The Quantitative Test
An individual must spend at least 750 hours per year actively managing their rental portfolio. This must be their primary occupation. In other words, you must expend more working hours running your rental portfolio than you do in any other profession.
If you’re someone who spends 1,500 hours per year at your day job and fills 750 hours of your time managing your rental property, you will not meet a Real Estate Professional qualification. You would need to work 750+ hours in real estate and spend fewer hours at your other job.
Pursuits that count toward that 750-hour threshold include: supervising repairs or renovations to a property, privately performing construction activities, selling a property, and showing and/or renting your rentals.
Time that does not count includes ancillary investment activities, such as investigating new opportunities and time spent “on-call” for residents. Travel time is seldom acceptable toward the 750-hour minimum, but IRS rulings have varied – so those wanting to be conservative may not want to include this time in their overarching calculation.
Technically, the IRS prefers that a 750-hour minimum is invested into each rental property. However, the IRS does permit grouping assets by selecting all of those interests as a single activity. By doing so, you are required only to spend 750 hours across your entire rental portfolio.
As a standard caveat, the IRS wants you to have at least a 5% ownership stake in all of the rental properties for which you are professing to be a Real Estate Professional.
In aggregate, memorize this method: 750-hours + 50% or more of your time + 5% ownership stake.
2. The Material Participation Test
To achieve Real Estate Professional status, you must “materially participate” in each rental asset.
According to the IRS, the following activities qualify toward material participation: “Real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” You are required to perform these tasks, all or in part, on a regular, continuous, and “substantial” basis to be deemed a Real Estate Professional.
The IRS utilizes a 500-hour threshold to circumscribe material participation that spans industry classifications, an easy bar to attain for those in the real estate industry. Real Estate Professional designation has a 750-hour threshold requirement already.
A significant clarification to make: material participation does not mandate managing properties day-to-day. It is possible to employ a property manager and still supervised the threshold. Besides, it is not necessary to have a real estate license to qualify.
We discussed above that hours spent on investment exercises do not count toward the Quantitative Test. Still, activities as an investor (e.g., studying and reviewing financial statements, generating reports of finances or operations, or managing the finances) can be included in the Material Participation Test – if you are supervising your asset(s) day-to-day.
Beyond the above, these activities do not qualify.
· As noted above, investing in assets as a limited partner does not qualify for either the Quantitative Test or the Material Participation Test.
· You and your spouse CANNOT combine your hours spent on your rental portfolio to reach the 750-hour minimum threshold. One of you needs to meet both requirements independently.
· An enterprise (such as an LLC) may pass as a Real Estate Professional if greater than 50% of the gross receipts for the business are from real estate.
Required Real Estate Professional Documentation
There are undeniable advantages to obtaining Real Estate Professional status, but it is a designation that most people grapple with achieving. The IRS takes this designation sternly and will audit those who seem unlikely to reach the threshold. Accordingly, if you’re a high-earning professional operating in another field, the IRS may find it unusual that you also lend more than 50% of your time supervising your real estate portfolio.
Anyone who’s contemplating filing as a Real Estate Professional will want to preserve accurate records in the event of an audit. The IRS states that an individual can prove their Real Estate Professional status by any “reasonable means,” which the IRS does not specify.
Tracking systems are critical:
· Use an email account reserved for all real estate endeavors and communication. This makes it more straightforward to find and track emails if needed for an audit.
· Log all calls as they occur. In your log, record notes to define the reason for the call.
· Use an earmarked calendar to keep up with all meetings, events, site visits, etcetera., linked to your rental portfolio. Again, make comprehensive notes about each of these appointments to use as reinforcement if needed.
· Open a bank account that is only used for your rental assets. Similarly, have a credit card that is designated exclusively for rental property expenses. You want to be careful not to mix or co-mingle funds (personal and those related to your portfolio).
· Use accounting software (and hire an accountant) to keep up with all of your income and expenses in real-time. Remember: If the IRS questions your position on an audit, then the onerous responsibility of showing you qualify falls squarely on your shoulders.
Strategies for Becoming a Real Estate Professional
We’ve alluded to this already, but it’s essential to reiterate: becoming a Real Estate Professional is no easy task for those with already-demanding day jobs. Still, it is not impossible to qualify, particularly for married couples where one spouse is otherwise unemployed.
Here are a few approaches for becoming a Real Estate Professional:
1. If you are now employed full-time, you can have your spouse pursue the designation. Of course, your spouse has to produce the work – not just say they’ll do the job. Confirm your spouse is on board with this approach. You’ll want to review the criteria closely and to ensure your spouse is up for the task.
2. If you work part-time (or could work part-time), assess the number of hours you spend working at your other job and determine whether you’d be able to spend 50% of your spare time running your real estate portfolio.
3. If you’re retired, take on more of your real estate portfolio’s day-to-day administration. You may find that you’re now spending 500+ hours on your rental properties each year, in which case raising your time spent could speedily put you over the threshold required to qualify.
Conclusion
It might make sense to evaluate whether or not to become a Real Estate Professional. It’s undoubtedly not the right move for everyone, particularly for already high-income-earning people who are better off concentrating on their day jobs than their real estate portfolios. That said, it’s a relevant designation to at least be aware of. Conceivably, this may not be the right season of your life to seek the status. Perhaps this isn’t something you’d want to reconsider until way down the road.
Figuring out how your rental income is taxed – and how to lessen that tax burden potentially – is necessary for anyone interested in maximizing their rental income.