Ralph was a local franchise business owner who also invested in real estate, spending more hours on real estate than his business. He did employ a property manager, but was actively involved in supervising and asset management. This qualified him as a Real Estate Professional.
Ralph was able to use the depreciation deduction on his properties to create a passive loss, which offset his business income and therefore left his tax burden much smaller. Cost segregation studies helped to increase his depreciation losses and shelter much of his income from tax.
For savvy investors seeking to optimize their tax strategies, achieving Real Estate Professional status can be a game-changer for taxes, as it was for Ralph.
Requirements for Real Estate Professional Status
To qualify as a Real Estate Professional, an individual must satisfy two primary criteria established by the Internal Revenue Service (IRS):
- Material Participation: The taxpayer must spend more than half of their total working hours during the tax year on real property trades or business. Material participation involves actively engaging in the day-to-day operations, decision making, and management of real estate activities.
- Time Commitment: The taxpayer must dedicate more than 750 hours per tax year to real estate property trades or businesses. This includes activities such as property management, acquisition, development, or other real estate related tasks.
- There are 11 permitted real property trades and businesses: real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade. If you are involved in several of these trades at once, you may be able to group the activities together.
Meeting these criteria should involve record-keeping to document the time and effort expended on various real estate activities. Be aware that the status as a Real Estate Professional on your taxes essentially moves your income from “passive” to “active”, which is why passive loss can be used to offset other income. However, if you have positive income instead of a loss, payroll taxes (Social Security and Medicare) would be due on this income, as it is now considered self-employed income by the IRS.
Benefits of Real Estate Professional Status
- Passive Loss Deduction: Perhaps the most significant advantage of attaining Real Estate Professional status is the ability to deduct passive losses against non-passive income. Normally, losses from rental real estate activities are considered passive and can only offset passive income. However, as a qualified Real Estate Professional, you can use these losses to offset other forms of income, such as wages or business income.
- Tax Optimization: Real Estate Professional status allows investors to strategically manage their tax liabilities. By offsetting losses against other income, individuals can potentially reduce their overall tax burden, providing a valuable tool for planning and optimization. If you have a spouse with significant earned income, your passive losses can offset their active income as well.
Conclusion
For investors like Ralph, deeply involved in real estate activities, the benefits of real estate extend far beyond immediate financial gains and transform into long-term tax advantages.
As with any tax-related matter, seeking the guidance of a qualified tax professional is advisable to ensure compliance with regulations and to make the most of the opportunities presented by Real Estate Professional status.
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