There are numerous career opportunities available within the real estate industry. These include Realtors, agents, brokers, attorneys, investors, and more. However, just because you have a job in real estate does not necessarily mean you qualify as a real estate professional in the eyes of the IRS. This designation is used to provide some of the many tax benefits associated with real estate, but there are specific criteria to meet before you can be eligible. Keep reading to learn more about who qualifies as a real estate professional and how this designation can help when tax season comes around.
Real Estate Professional Tax Benefits
Real estate ownership is known to provide several tax benefits, but did you know there are even more perks available to those who qualify as real estate professionals? This tax-specific designation lets qualifying investors deduct business expenses, losses, and property depreciation from their overall taxable income. In contrast, an investor who doesn’t meet the criteria of a real estate professional would only be able to use losses as a way to offset rental income or capital gains.
For example, let’s say you had $25,000 in losses (perhaps due to property vacancies) and an additional $15,000 in depreciation across your rental portfolio. In this example, you made $170,000 in annual income. If you were classified as a real estate professional, the combined $40,000 could be deducted from that $170,000. This would lower your overall taxable income to $130,000 for the tax year. If you did not meet the real estate professional requirement, these losses could only be used to decrease your rental income. That being said, the IRS set forward certain rules that determine whether an investor meets the real estate professional classification.
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Real Estate Professional Rules
The IRS Publication 925 establishes the criteria necessary to qualify as a real estate professional for tax purposes. There are a few different ways to look at these rules, but generally speaking investors are required to spend a certain amount of time per year working in real estate. The real estate professional rules are as follows:
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More Than 50% Rule
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750 Hour Requirement
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Single Taxpayer Requirement
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Material Participation
More Than 50% Rule
The first qualification set forth by the IRS states that more than half of the services performed within the tax year were in “real estate property trades or businesses.” This is commonly referred to as the more than 50 rule, meaning more than 50 percent of your working hours must be in real estate. The more than 50% rule generally eliminates anyone with a full-time job outside of real estate from being classified as a real estate professional. For example, if you work 40 hours a week at Google and spend about 5 to 10 hours per week managing a rental property — you will not qualify as a real estate professional when tax season comes around.
750 Hour Requirement
The second qualification for real estate professionals requires them to spend more than 750 hours in a year performing services related to real estate trades or businesses. To put that in perspective, a typically 9 to 5 employee works between 1600 and 1900 hours per year. The 750 hour requirement is calculated annually (from January to December) and there is no limit on when the hours are worked — so long as they fall within the tax year. The activities that count towards this professional requirement include:
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Rental unit management
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New Construction
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Property and business operations
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Time spent as a real estate agent or broker
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Property development or redevelopment
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Property acquisition
Real estate professionals are also generally told to consider their property interests as one business activity rather than separate businesses. That way, property management and operations on each home count towards the 750-hour requirement (versus each property having its own 750-hour requirement). Further, keep in mind that real estate professionals must document and prove these hours to the IRS.
Single Taxpayer Requirement
The above qualifications must be met by each person hoping to receive the real estate professional tax designation. In other words, you cannot combine hours with your business partner, and both receive the real estate professional tax benefits. Each taxpayer must prove the 50 percent rule and 750-hour requirement annually to be considered. However, there is an exception for married couples filing jointly. If you or your spouse meet the above requirements, the benefits of being a real estate professional would apply to your combined income — even if one spouse earned their primary income outside of real estate.
Material Participation
The IRS uses a system called the material participation test to determine if your working hours can count towards your designation as a real estate professional. These tests are a way for investors to prove that they materially participate in real estate business activities — rather than acting as passive owners. Generally speaking, you must meet at least one out of seven material participation criteria. One of the most common examples is to participate in the activity for at least 500 hours. As you might guess, this is frequently used because professionals must already prove that they work 750 hours in real estate. Be sure to identify all of the businesses or real property trades that you materially participate in.
How To Document Real Estate Professional Status To The IRS
The IRS will require supporting documentation before you can receive real estate professional tax status. This can be done in any method you prefer: Excel workbooks, Google sheets, time-tracking websites,, etc. The IRS does not have any requirements for submitting these hours, though they will require you to be consistent during the tax year. Investors should also try to maintain their system throughout the year, rather than putting it together at once. There are a few different things the IRS will look for when reviewing your hours:
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The time and date
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The activities performed
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The duration of your work time
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The address of your work or related property
How To Document “Unprovable Time”
It may seem impossible to count all of your working hours over a year; after all, things can come up unexpectedly. These situations, where there is no supporting evidence, are referred to as “unprovable time,” and there are guidelines you should follow before documenting them. The IRS will generally apply a reasonable test to these hours. For example, it sounds reasonable to spend 6 hours repairing a water leak on one of your rental properties. However, if you document these repairs as 48 hours straight, it may raise some red flags with the IRS.
If you want to document unprovable time, be careful not to exaggerate or stretch your hours for the sake of meeting minimum requirements. This could jeopardize your credibility and ultimately undermine your efforts to become a real estate professional. A general rule is to imagine what you would say when reporting your “unprovable time” directly to an auditor.
Will Passive Investments Help You Qualify?
Passive investments typically will not help you qualify as a real estate professional. As mentioned above, the IRS have strict criteria for determining who qualifies. Real estate professionals need to be able to prove a minimum number of hours worked, among other things, making it difficult for passive income investors to meet the requirements. Passive income investors may spend a few hours a week or month checking in with their property managers, but this is typically not enough involvement to meet the IRS standards.
If your “passive investments” do require substantial time and work on your part, consider documenting your involvement. This information can help you determine if you do qualify, and potentially even realize that your role is not so passive after all. Either way, there are numerous other tax benefits to real estate investing to be aware of — whether you are a real estate professional or not.
Summary
Tax benefits are one of the most attractive perks associated with real estate investing, which is why it’s crucial to know how to use them to your advantage. When it comes to being a real estate professional, investors can use losses and depreciation to their advantage. Remember that documentation is required to meet the IRS requirements stated above. Work with a qualified tax professional as you navigate the qualifications, and let yourself enjoy the many benefits of real estate investing.
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