Can self storage facility owner/operator qualify for REP status?

Question

Can a self storage facility owner/operator qualify as a real estate professional if it is their full time occupation, and meet the 750 hour material participation and greater than 500 hour rental real estate activity safe harbor rulse? Has anyone been able to achieve this?

Also, can self storage facility renting/managing activity hours count towards the real estate professional requirements if one also owns and self manages multifamily or single family homes or is a real estate agent helping people buy and sell homes?

Thanks in advance for your input!

Bilal

Ashish Acharya · Answer

Yes it does.

Yes, agent hours counts towards the status.  There is a court case on that. Search Agarwal.

Managing properties, yes.

Andrew Reyes · Answer

Hi @Michael Wagner,

In many cases a property producing positive cash-flow can simultaneously produce tax losses. This is due to non-cash deduction (i.e. depreciation). In this case you get the best of both worlds: cash flow to reinvest and tax losses to reduce your tax liability on other sources of income. Hope this is helpful.

Generally:

NOI - Cap Ex - Debt Service = Cash Profits

NOI - Depreciation - Debt Service = Taxable income

Most non-residential real property is depreciated over 39 years so 2.6% of your purchase price is taken as a tax deduction in each year. Residential is slightly accelerated to 27.5 years so 3.63% of your purchase price.

Assume the following: $100 acquisition (4 cap), 2x debt-coverage ratio and no cap ex. NOI is $4 ($100 * 4%) per year, debt service is $2 ($4 / 2) leaving you with $2 ($4 - $2) of cash profits. $2 of cash profits are further redacted by $2.6 ($100 * 2.6%) of depreciation resulting in a tax loss of $0.6. Add some 0s to the end of these numbers and you may be able to see how being a real estate professional is beneficial.

Additionally, if you have a cost segregation study you may be able to categorize some of the $100 purchase price to shorter life assets resulting in greater tax losses in the earlier years.

This example is illustrative so speak to your tax professional to understand the application to your specific situation.

Bilal A. · Answer

@Michael Wagner @Christopher Smith

I am not able to put things as eloquently as @Andrew Reyes and @Ashish Acharya and neither am I a CPA or qualified to give tax advice.

My situation is a bit different than a full time investor. A high income W2 employee has very few choices to mitigate high income tax rates. In states like MN, ordinary income tax rates reach about 50% when counting federal income tax, state income tax, and AMT. Quitting your day job is not realistic in most cases but having your spouse qualify as a real estate professional is a very powerful tool, which can potentially allow you to use real estate related “losses” and depreciation to offset your AGI.

This is not say that one would buy real estate purely for the tax benefit. But buying a recession resistant real asset for the RIGHT price gives you passive income and lowers your overall income tax bracket while building equity and potential future appreciation over time. Creating enough equity and passive income can allow one to break the proverbial “golden handcuffs” of a high paying job in a matter of years or at least that is goal.

Michael Wagner · Answer

I'm with you on all of the above!  But unless this is part of a longer term plan that includes 1031 exchanges until death (or another TRUE tax "savings" strategy like an Opportunity Zone) wouldn't the investor be paying real money (in the form of increased taxation when moving from Passive investor to Active Investor-passive gains vs. earned income) in exchange for tax DEFERRAL....Eventually the tax benefit known as depreciation needs to be re-captured. With that, I view this strategy as POTENTIALLY paying real money up front for merely delaying a tax burden.  Tax savings through depreciation (whether standard or accelerated) are essentially a 0% loan from the government but it must be repaid when recaptured.  As such, that 0% loan MAY turn into a loan with REAL costs if obtaining it requires one move from passive income to active income. Those costs should be weighed against the return one can make on the deferred dollars between today and whenever recapture takes place.  I'm not denying anything presented above or saying that depreciation and tax deferral isn't beneficial...I'm just suggesting that there are many newer investors who think "depreciation" is more valuable than it actually it. Its a benefit but can come with a cost that should be factored in.

Ashish Acharya · Answer

REP are not subject to 3.8% NIIT tax if he/she were subject to. That is a huge saving to some people. REP does lot more. So, that is why we say, each individual needs planning differently.

Andrew Reyes · Answer

@Michael Wagner you raise an excellent point that depreciation deductions are recaptured when the property is sold. The Note that the recaptured depreciation is taxed at a lower rate (25% max as of 2019) compared to the ordinary deduction (37% max as of 2019). This is true tax savings of 12% on operating income and the added benefit of deferring the tax until sale. Additionally, the gain on sale (including depreciation recapture) generally is not be subject to self-employment tax. If you have tax losses during operations and taxable gain on sale it is likely that none of your profits would be subject to self-employment tax and the operating losses could reduce other income.

@Christopher Smith I believe that the business fundamentals of a deal should be the deciding factor in making any investment. Tax is an added cost to be analyzed and should be properly planned for. Ultimately if the fundamentals do not make sense tax costs or benefits do not matter. Again, I would let the business fundamentals drive the train. This may result in taxable income on an annual basis. However, I personally would not have that as a requirement. All else being equal, paying less tax is better than paying more.

Bilal A. · Answer

@Ashish Acharya Thank you!

Michael Wagner · Answer

I'm not the one to answer this question for you but it looks like you get them answered above. I'd like to add to the conversation though if I may.  Help me understand why one would WANT to be classified as a Real Estate Professional?  From a taxation standpoint, wouldn't one WANT the profits from self storage investing to be treated passively rather than as earned income?  Perhaps this would make sense if your self storage investment is losing money and you want to capture the losses?  But losing money to pay less taxes doesn't seem logical to me so I guess I'm just confused here.  I'm sure there's a benefit you are after here, would you mind sharing what that is to educate guys like me;)

Christopher Smith · Answer

Not sure losing money is the best of both worlds, (even after tax depreciation). I have always insisted that my RE investments make money, (even after tax depreciation). That to me is really the best of both worlds.

Can self storage facility owner/operator qualify for REP status?

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