Why
would someone want the tax advantage to qualify as a real estate
professional?
And how to keep track
of 750 hours actively working a year to meet the second of two criteria (IRC
Sec. 469(c)(7)(B):
Qualifying as a real estate professional (REP)
under IRC Sec. 469(c)(7)(B) can offer several tax advantages for taxpayers who
own and actively manage rental properties. Here are some of the key benefits:
1. Deducting rental losses against non-passive
income: Typically, rental property losses are considered
"passive" income and can only be used to offset passive gains (like
other rental income) or up to $25,000 of non-passive income ($12,500 if married
filing separately). However, if you qualify as a REP, your rental activities
become "active" and you can deduct losses from them against any type
of income, including your salary, wages, or self-employment income. This can
significantly reduce your overall taxable income.
2. Avoiding the Net Investment Income Tax (NIIT):
The NIIT is a 3.8% tax on certain net investment income, including some rental
income, for high-income taxpayers. But if you qualify as a REP, your rental
income is exempt from the NIIT.
Net
Investment Income Tax (NIIT): Explained with Examples
The Net Investment Income Tax (NIIT)
is a 3.8%
tax levied on certain types of investment income earned by individuals, estates, and trusts above
specific income thresholds.
Here's a breakdown of the key points:
Who
pays NIIT?
- Individuals: Single
filers with modified adjusted gross income (MAGI) exceeding $200,000, married
couples filing jointly with MAGI exceeding $250,000, and married
couples filing separately with MAGI exceeding $125,000 are subject to
NIIT.
- Estates
and Trusts: Estates
and trusts with taxable income exceeding $25,000 also pay NIIT.
What
income is subject to NIIT?
- Net
Investment Income: This
includes interest, dividends, capital
gains (net of losses), passive
income from partnerships and S corporations, royalties, rental real
estate income (unless you qualify as a real estate professional, see below), and income
from non-qualified annuities.
- Important
exclusions: Gains
from the sale of your primary residence, qualified
retirement distributions, and
some other types of income are not subject to NIIT.
How
is NIIT calculated?
NIIT
is applied at a rate of 3.8%
to the lesser of:
- Net
investment income: The total
amount of your investment income as mentioned above.
- Excess
MAGI: Is
the amount your MAGI exceeds the income threshold for your filing status.
Examples:
Example
1:
Sarah, a
single taxpayer,
has a MAGI of $220,000
and $40,000
in net investment income.
Since her MAGI exceeds the threshold of $200,000
by $20,000, she will pay NIIT on
$20,000, resulting in a tax of
$760 (20,000
x 3.8%).
Example
2:
John and Mary,
a married couple filing jointly,
have a MAGI of $280,000
and $60,000
in net investment income.
Their MAGI exceeds the threshold of $250,000
by $30,000. However, the lesser amount for
NIIT calculation is their net investment income of $60,000. Therefore, they will pay NIIT of
$2,280 (60,000 x 3.8%).
Real
Estate Professionals and NIIT:
If
you qualify as a Real Estate Professional (REP) under specific IRS criteria, your rental income is not considered passive and is therefore exempt from NIIT. This can be a
significant tax advantage for real estate investors who actively manage their
properties.
- You can find
additional resources and details on the IRS website: https://www.irs.gov/individuals/net-investment-income-tax
3. Deducting qualified business expenses:
As a REP, you can deduct all ordinary and necessary business expenses related
to your rental properties, such as repairs, maintenance, advertising, property
management fees, and travel expenses. This can further reduce your taxable
income.
4. Using the home office deduction:
If you use a portion of your home exclusively and regularly as your principal
place of business for your real estate activities, you may be able to deduct a
portion of your home office expenses.
Here are the two key criteria you must meet to
qualify as a real estate professional under IRC Sec. 469(c)(7)(B):
- Active
participation: You must spend more than 750 hours
during the tax year participating in real estate activities (either
personally or through employees).
- Material
participation: Your real estate activities must make up
more than 50% of your total personal services performed during the tax
year (or at least 100 hours if that's more than 500 hours).
It's important to note that qualifying as a REP can
also have some drawbacks. For example, you may be subject to self-employment
tax on your rental income, and you won't be able to claim the standard
deduction if you itemize your deductions. You need to have a pencil with your
last year’s IRS return and add up all the differences before you embark on this
plan. Measure if it helps and if you really spend 750+ hours or nineteen weeks
of full-time work. Material participation in income-producing
activities is defined as regular, continuous, and substantial. Income-producing
actions, in which the taxpayer materially participates, are active income or
loss. You are on the phone, meeting contractors at the site, checking on
repairs, researching cost savings…
A “real estate professional” to meet this bar, a taxpayer must
meet the following two criteria (IRC Sec. 469(c)(7)(B):
1. More than one-half of the personal services performed in all
trades or businesses by the taxpayer during such taxable year are performed in
real property trades or businesses in which the taxpayer materially
participates,
2. Such taxpayer performs more than 750 hours of services during
the tax year in real property trades or businesses in which the taxpayer
participates.
You must also meet material
participation requirements for each rental (or group; the
activity).
For couples married filing jointly, one spouse must achieve
both no.1 and no. 2 on their own
Size of your rental portfolio matter? In Smith v. Commissioner, T.C. Summary Opinion 2014-112,
the taxpayer was a 63-year old disabled veteran. He had no other job due to
being disabled and made himself available 24/7 to take care of his one
three-unit property. The Court agreed that he qualified as a real estate
professional even though he only had one property.
Having a property management business or being a real estate
agent may help you qualify for Real Estate Professional Status (REPS) but it
isn't a requirement.
Just create a log of the hours spent managing the properties.
The two requirements to claim real estate
professional status are
1) Spend 750 on real estate related activities
2) Spend more time on real estate than a W-2 or a
business.
There is no requirement about being an employee
and payroll compensation.
I am not a tax
professional and this is not tax advice
