The Real Estate Professional Tax Loophole

The Real Estate Professional status is a designation given by the IRS based on the number of hours that you work in real estate activities versus other activities. It doesn’t mean that you have to become a real estate sales agent or broker. You don’t need to drive around showing people houses or putting out “for sale” signs.

The Real Estate Professional designation means that you spend a certain amount of time in real estate activities. Now, that could include being a real estate agent. Or it could mean that you spend time locating, renovating, leasing, or otherwise developing your own real estate portfolio.

Real Estate Professional benefits

To understand the benefit of the Real Estate Professional status, we first need to discuss the tax benefits that come with real estate ownership. Real estate investing, defined here as holding property for rent or lease to others, is a great way to create a cash flow that isn’t taxable.

That’s due to the “phantom expense” of depreciation. Depreciation is a non-cash deduction that lets you reduce the amount of taxable income. So, it’s very possible to create cash flow month after month and not pay tax on it.

In fact, you can generally have “paper losses” with real estate at the same time that you have cash flow. That’s the best of all worlds–cash in your pocket plus a phantom loss that offsets other income!

That’s great, as long as your income is $100,000 or less per year. In that case, you can take a real estate loss of $25,000 per year against other income. If you make over $150,000, you can’t take any real estate loss. And, if you make somewhere between $100,000 and $150,000, the amount of allowed loss phases out.

Here’s the way around that! Qualify as a Real Estate Professional. If you can qualify for this designation, then you can take an unlimited amount of real estate paper loss against your other income, no matter how much you make or how much the real estate loss is.

At the end of this article is the Real Estate Professional “Test of Hours” that we use at my CPA firm to verify the status. This is a test you want to pass!

Real estate activities

To complete the Real Estate Professional test, you will need to allocate how you spend your time between regularly paid activities and real estate activities. A qualified real estate activity is any thing in which you “develop, redevelop, construct, reconstruct, acquire, convert, rent, operate, manage, lease, or sell” real estate.

Remember that the key is that you perform personal services in these activities, but you don’t necessarily have to be the one performing the work. You can be supervising, meeting, planning–all of the activities that go into truly running a business.

Develop
This would include meeting with engineers, architects, planners, equipment operators, construction personnel, drafters, financial professionals, accounting and legal professionals, etc. to discuss and implement development of property.

You could also be involved in actually performing some of the development work yourself, if you have such skills, or it could be time you spend hiring professionals, supervising their work, reviewing plans, and/or inspecting the work. This development could be anything from subdividing property, with no additional amenities added, to actual construction of real property.

Redevelop
This would include meeting with engineers, architects, planners, equipment operators, construction personnel, drafters, financial professionals, accounting and legal professionals, etc. to discuss and implement demolition of structures and/or redevelopment of the property.

Again, you could be involved in actually performing some of the development work yourself, if you have such skills, or it could be time you spend hiring professionals, supervising their work, reviewing plans, and/or inspecting the work.

Construct
As before, any meetings, planning, hiring, firing, supervision, or inspection of any phase of construction is considered performing this activity.

Reconstruct
Just as with “construct,” qualified activities under “reconstruct” are any ones which are necessary to this phase of building.

Acquire
Acquiring a property has many phases–meeting with sales people, looking at a whole range of properties, preparing an offering, responding to counter-offers, arranging financing, meeting with insurance agents, inspections, and actually closing a property. You don’t need to acquire a property to rack up a lot of hours in this area.

Convert
Conversion of property is similar to redevelopment or reconstruction, but might have the additional time element of meeting with planning officials. All of that time counts toward your qualified real estate time.

Rent
The time spent meeting with your property managers to establish rental criteria, as well as acting as renting agent yourself (including the showing, screening, advertising, etc.), will count as qualified real estate time.

Operate
If you spend time as a property manager, or meet with your property manager, then you will spend significant time as the “operator” of real estate.

Manage
Similar to “operation” of real estate, if you manage your property, its tenants, prospective buyers, etc., then you are involved in qualified real estate activity.

Lease
The time spent meeting with your property managers to establish leasing criteria, as well as acting as renting agent yourself (including the showing, screening, advertising, etc.), will count as qualified real estate time.

Sell
All of the activities involved in selling a property (getting ready for sale, setting up open houses, placing ads, meeting with real estate brokers and prospective buyers) count toward qualified real estate time.

What if you’re considered a Real Estate Professional?

If, after taking the Real Estate Professional “Test of Hours,” you discover that you really are a Real Estate Professional, there are still a few things you need to do.

We recommend that you keep good track of the hours you spend in real estate by keeping a paper diary or using a PDA to record the hours. If you have another non-real estate occupation, we also recommend that you track those hours as well.

DKA Real Estate Professional “Test of Hours”

The Real Estate Professional status is unrelated to the issue of dealer, developer, or investor status of the property. This test is strictly a test of hours spent in real estate activities. Review the real estate activities list prior to completion of the following.

1. Does a company engaged in a real estate activity in which you own 5% or more of the company currently employ you?

  • If the answer is yes, you are a Real Estate Professional.
  • If the answer is no, continue with 2.

2. Do you work outside of the home?

  • If the answer is no, then go to 4 below.
  • If the answer is yes, go to 3 below.

3. Do you spend more hours in real estate activities on an annual basis than you do in your other business?

  • If the answer is no, then you cannot qualify as a Real Estate Professional.
  • If you’re married and file a joint return, have your spouse complete this portion of the questionnaire.
  • If the answer is yes, then go to 4 below.

4. Do you spend a minimum of 750 hours per year in real estate activities?

  • If you answered yes and have no other profession, you are a Real Estate Professional.
  • If you answered yes and passed the test of 3. above, you are a Real Estate Professional.
  • If you answered no, you cannot be a Real Estate Professional.

By CREOnline Contributor

A content contributor to the original CREOnline.com.