The Power of the Real Estate Professional
In general, rental activities are passive activities even if a taxpayer materially participates in them. But, if a taxpayer qualifies as a real estate professional, the rental real estate activities in which the taxpayer materially participates are not considered passive activities. To say it differently, a real estate professional who materially participates in a real property trade or business is not subject to passive activity limitation rules and may use rental losses to offset other sources of non-passive ordinary income.
There are two eligibility requirements for a taxpayer to be a real estate professional:
- 50% test. More than half of the personal services performed in trades or businesses during the tax year are performed in real property trades or businesses1 in which the taxpayer materially participates.
- 750 hours test. A taxpayer must perform over 750 hours of services during the tax year in real property trades or businesses that the taxpayer materially participates in.2
A taxpayer cannot count personal services performed as an employee in real property trades or businesses, unless the taxpayer is a 5% owner of their employer (in other words, more than a 5% owner of the employer’s capital or profits interest, outstanding stock or outstanding voting stock). For a joint tax return, a taxpayer can count their spouse’s participation in an activity in order to determine material participation, but the spouse’s personal services cannot be used to determine the requirements bulleted above.
Another benefit to the real estate professional designation is the ability to avoid the 3.8% tax on passive net investment income, assuming of course that the rental income is derived in the ordinary course of a trade or business and the rental activity is not a passive activity under existing law.3
A potential downside to the real estate professional status is state nonconformity. A taxpayer may be a real estate professional for Federal income tax purposes, but not for certain states. California, for example, does not recognize the real estate professional designation for state income tax purposes.
At CLA, we work with our clients holistically, combining our tax and wealth knowledge to help plan for the future and reduce risk. Please contact us to get started on planning opportunities that can improve your financial future. Thank you to Devante Wilson for his assistance with this blog post!
1 A real property trade or business is a trade or business that does any of the following activities with respect to real property: development, re-development, construction, re-construction, acquisition, conversion, rental, lease-up, operations or brokerage.
2 The Internal Revenue Service requires taxpayers to maintain (and retain) detailed records to support the hours worked in real estate versus those worked in other businesses. It is recommended that taxpayers keep records for three years from the date the original tax return was filed or two years from the date the tax was paid, whichever is later.
3 If a real estate professional participates in more than 500 hours in the current tax period (or more than 500 hours per year in any five of the previous ten tax years, whether or not consecutive), there is a safe harbor rule that considers the rental income associated with the activity to be derived in the ordinary course of business.
Sources: Internal Revenue Service, Bloomberg Tax
- Carey M. Heyman, CPA
- Managing Principal of Industry - Real Estate
- CliftonLarsonAllen LLP
- Century City (Los Angeles)
Carey is the Managing Principal of the Real Estate Industry at CLA. He is a trusted advisor with close to 20 years of experience providing accounting, assurance, tax, and consulting services to real estate industry owners, operators, family offices, developers and syndicators. Carey has a strong track record of helping clients build and retain capital by leveraging tax- and cost-saving strategies and employing tax credits and incentives. He also consults with high net worth individuals, large family groups, and owners of closely-held businesses on all aspects of tax planning, estate planning, and retirement planning.
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