Minimizing Taxes as a Real Estate Professional
To be, or not to be, that is the question:
Whether ‘tis nobler on your tax return
to act as a real estate professional in your real estate business,
Or to invest for passive income – and end the tribulation.
Thanks for playing along with my adaptation from Hamlet. Just like Shakespeare in high school, understanding the best way to report your income or, more importantly, losses from real estate can be difficult. Knowing what to do with that income or loss on your tax return can significantly affect the amount of taxes you pay each year.
After filling out your Schedule E, any profit is reported to your 1040 and taxed as ordinary income on your tax return. But, as a real estate investor, particularly in a year like 2020, it is not uncommon for properties to produce a net loss for tax purposes due to depreciation and expenses. Meaning you won’t have to pay taxes on your rental income, even if you have positive cash flow.1 In fact, you may be able to use those losses to offset ordinary income as well if you materially participated in your real estate business during the year.
What is Material Participation?
Each tax year material participation is determined by the type of work you do and the time you invest. You must satisfy one of seven different tests outlined on page 5 of IRS Publication 925 to qualify as a material participant in your business. These tests are2:
- 1. You participated in the activity for more than 500 hours.
- 2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- 3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
- 4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 CAUTION ! hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
- 5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
- 6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
- 7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year (if more than 100 hours).
Did you qualify? If so, you may be able to use up to $25,000 of your real estate losses to offset ordinary income you earn throughout the year. However, there are restrictions if you make over $100,000 in adjusted gross income, so I encourage you to learn more by reading through the IRS publication on passive activity loss limitations.3
What if I make more than $100,000 or Want to deduct more than $25,000?
To remove the income limit from passive activity losses and to be able to deduct more than $25,000, you need to be a material participant and a “real estate professional” as defined by the IRS. To qualify as a real estate professional, you must meet these two requirements4:
- More than half of 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.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Although no one invests in real estate for actual losses, knowing what to do with paper losses is important. The actual losses incurred from the effects of COVID-19 and any paper losses that real estate investors already have could make a significant difference in your 2020 taxes if you qualify as a material participant and a real estate professional. You still have six months of the year left, but you must qualify to reap the benefits.
Disclosure: I am not a tax professional. Make sure to talk with a qualified tax advisor to discuss the details of your specific situation and any suggestions they recommend to accurately log your activities.
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