Tax Advantages Available for Real Estate Professionals

Qualifying as a real estate professional is not easy. On the bright side, if you qualify as a professional real estate, you are entitled to an income tax treatment that can benefit you.

Tax Benefits for Real Estate Professionals Going Through Rental Losses

All rental operations are typically treated as passive activities, regardless of the individual owner’s level of involvement.  Taxpayers may typically only use passive losses to offset income and benefits from other passive activities.  If the taxpayer doesn't have enough passive income to offset passive losses, the additional losses can't be used at the moment and are pushed forward to future years instead.

For the "Real Estate Professional," an exception to this principle is made. The premise is that someone who makes their money in real estate business should be able to use losses without restriction.

If the taxpayer is actively involved in the rental transaction, real estate practitioners may otherwise view passive rental real estate practices as nonpassive.  Losses from such activities, such as wages and interest, can be used to offset any other income.  This preferential treatment is available only to eligible individual taxpayers who are considered to be substantially involved in the rental activity, qualifying under certain very specific rules.

Who Qualifies as a “Real Estate Professional?”

Step 1 – PARTICIPATE IN REAL PROPERTY TRADE OR BUSINESS

In order to be eligible for special property professional rules, the taxpayer must participate in real estate trades or businesses instead of participating in real estate transactions in business activities.

A real estate trade or company is broadly defined to include real estate development, renovation, construction, reconstruction, acquisition, sale, rent, service, management, leasing or brokerage (a real estate broker, not a mortgage broker)

Step 2 - MEET THE FOLLOWING REQUIREMENTS:

• More than 50% of personal services provided by the taxpayer in all businesses or trade during the tax year are carried out in real estate undertakings in which the taxpayer is substantially involved, and
• During the tax year, the taxpayer carried out more than 750 hours of service in real estate trades or businesses in which the taxpayer was substantially involved.

Generally speaking, if the real estate professional is involved in multiple activities, the rules require the taxpayer to participate substantially in each rental activity, meeting the requirements of 50% and 750 hours.  That may pose a burden that is difficult or even impossible, but there is a relief (see grouping later).

Material Participation Defined

The rules on product involvement list seven ways of establishing material involvement. It is necessary to meet only one of the seven tests.

Seven Product Engagement Tests:

• The taxpayer is active in the tax year's operation for more than 500 hours.
• The participation of the taxpayer was substantial for all the involvement of all individuals in the activity.
• During the tax year, the taxpayer participates in the operation for more than 100 hours and the involvement of the taxpayer is not less than that of any other person.
• The event is an "important participation activity" with a total participation of more than 500 hours in all major participation events. A person shall be treated as engaging substantially in a taxable year event if the individual engages in the activity during the tax year for more than 100 hours.
• The taxpayer was substantially involved in any of the five of the 10 tax years immediately preceding the activity.
• The activity is a personal service activity and the taxpayer was substantially involved for three years prior to the tax year.
• The person participates regularly, consistently and significantly throughout the tax year on the basis of all the facts and circumstances. The taxpayer must have engaged in at least 100 hours in order to fulfill this test.

Taxpayers should keep a log of time spent conducting these tasks to substantiate relevant involvement in the case of an income tax audit.

Another Potential Advantage for the Professional Real Estate

Taxpayers with taxable income above $200,000 (or $250,000 for taxpayers who file married-filing-jointly) are subject to the net investment income tax, which is an extra 3.8% surtax levied on the passive income of the taxpayer. Also, rental income is generally considered passive and this surtax will apply.  Nevertheless, if a taxpayer qualifies and wants to be known as a real estate agent, the net rental income will not be deemed passive and will not be subject to the net investment income tax of 3.8 percent.