How to Qualify as a Real Estate Professional For Tax Purposes

There are a number of tax advantages to filing as a real estate professional instead of as a real estate investor. The expanded tax deduction allowances alone make it worth it. However, not everyone is entitled to the real estate professional classification. Erroneously filing in this way leaves you vulnerable to monetary penalties, an audit or worse. Read on to learn how to be regarded as a real estate professional for tax purposes, and why it’s beneficial to do so.

What is a Real Estate Investor in the Eyes of the IRS?

The IRS has four categories for real estate investors; real estate investor, real estate dealer, real estate professional and real estate developer. We’ll be discussing two of these categories, the real estate investor and the real estate professional.

The initial criteria that the IRS uses to differentiate between a real estate investor and a real estate professional is how much the taxpayer is materially involved in their real estate investment. (There are other differentiations, which we will discuss later.) By default the IRS and a CPA would typically assume that the taxpayer is not materially involved in the real estate investment and should be classified as a real estate investor, unless proven otherwise. The term “materially involved” simply refers to the amount of active participation the taxpayer engages in; whether the income is derived from passive or active participation.

Why It’s Worth it to Try Qualifying as a Real Estate Professional

The major benefit of qualifying for real estate professional classification is that you get to deduct 100% of rentals depreciation and losses against both passive and active income derived from any source. In other words, your passive income losses and depreciation can offset ordinary income. This can be a significant benefit that could potentially allow a duly qualified real estate professional to show a zero tax liability for the tax year.

How to Qualify as a Real Estate Professional

For tax purposes, a real estate professional must spend a minimum of 750 hours each year conducting real estate business. That averages out to a little over 14 hours per week. Furthermore, a real estate professional will have active participation in a real estate investment. What that means is that the taxpayer must provide over half of their total personal services in aid of their real estate business.

What is Passive Income?

The IRS defines passive income as earnings made from investments where the taxpayer is not actively involved. Examples include:

• - turnkey rental property
• - Income from a joint venture investment
• - Income from a crowdfunded real estate investment

What is Active Income?

In terms of real estate, active income comes from money earned where the taxpayer is materially involved in a direct or hands-on way. For example:

• - Real estate property flips
• - Property renovations
• - Ownership of a real estate investment company

The IRS treats active income and passive income very differently. Here’s how it affects your taxes.

Things to Consider Before Filing as a Real Estate Professional

Give careful thought before filing as a real estate professional. This filing classification has far-reaching ramifications. For one thing, it means that all of your ordinary business income will be subject to self-employment tax. This usually necessitates you creating a legal entity such as an S-Corp, which will impact your ability to obtain financing for future real estate purchases.

Second, you can’t volley back and forth between tax years, changing your status between real estate professional and real estate investor; at least not without raising some red flags. This is a long-term decision that you’ll need to live with for many future years.

Speaking from personal experience, last year was the first one in which I filed as a real estate professional instead of an investor. The difference in my tax liability was astounding. I think you might be able to realize similar results if you can manage to make the transition to real estate professional.

If you’d like to learn more detailed information about how being a real estate professional gives you tremendous depreciation benefits, please refer to my article on Bigger Pockets, “How to Maximize Your Real Estate Deduction.”