June 13, 2022

Have you ever wondered why the real estate professional status exists? Real estate is a great way to build wealth over time. You have a stream of income, a hedge to cushion you against inflation, and there are great tax benefits such as several deductions.

Before 1986 was a great time to be a landlord while having a job that pays a lot. It was possible to deduct the real estate losses from their income as high-earning professionals. They could protect their business incomes using their real estate non-economic losses.  A doctor or dentist earning hundreds of thousands could invest in real estate and generate enough losses to offset their W2 income.

Already wealthy people being able to offset their entire income by investing in properties was a big problem. Therefore, the 1986 Tax Reform Act included the IRC Section 468, which removed tax shelter for real estate investors and landlords. Now, there are two categories of income: the nonpassive income (W2, 1099, Stocks, etc.) and the passive income, such as rental real estate.

Although this worked to remove tax shelters for the wealthy people, it also affected people running real estate investments as their major or active businesses. Therefore, in 1993, real estate investors lobbied Congress to develop the Real Estate Professional Status.

Benefits of the Real Estate Professional Status?

The Real Estate Professional Status (REPS) is a status given to people that work in real estate. This status gives them peculiar benefits such as converting significant passive losses like depreciation from real estate to ordinary losses, which are then deductible. This status allows them to reduce their tax liability. 

With REPS, you can offset ordinary income with rental losses, which will help you generate cash flow in the form of tax savings. You can then reinvest these tax savings into your rental property or buy more properties.

If you have a real estate professional status, you also do not have to pay the net investment income tax (NIIT) of 3.8%. Coupled with the ability to reduce your tax bill from about 35% to 15% or less, REPS is a pretty useful status.

How to Qualify for REPS

You may qualify for a Real Estate Professional Status. You only need a rental property and one rental activity that you materially participate in to qualify. The requirements include:

·      More than half of all your participation in any business or trade during the tax year must be in real estate.

·      More than 750 hours of participation in real estate property businesses or trades. There are 11 types of activities that qualify for these: rental, property development, brokerage trade or business, construction, redevelopment, reconstruction, conversion, acquisition, leasing, management, and operation.  

·      The material participation in these real estate activities must also be continuous, regular, or substantial.

As a litmus test, if you and your spouse have full-time W2 jobs, you most likely won’t qualify for REPS because you have to spend more time working in real estate than in your W2 job. To qualify while working a full-time job of an average of 40 hours weekly for 52 weekly, which makes 2080 hours annually, you’ll have to spend even more hours on real estate activities. Let’s assume this to be about 2500 hours annually. To work 4,580 hours annually, you do more than 114 hours of work weekly or more than 22 hours daily if you work only on weekdays. This is virtually impossible.

It’s also important to note that only one spouse or partner has to quality for REPS, even if it’s joint property. However, partners or spouses can’t combine their work hours to qualify for REPS.

Case Study

Imagine a taxpayer who is single, owns a real estate brokerage firm and makes $250,000 annually. He purchases a $500,000 long-term rental (LTR) property. However, the cash flow from the property is $20,000 because he purchased it in the middle of the year.

Since he already works in real estate, he qualifies as a REPS and materially participates in rental activities. He can generate $100,000 in bonus depreciation by reclassifying the personal property asset to reduce the depreciation time (cost segregation study) and another $30,037 in tax savings by being a real estate professional.

Because it’s so powerful, Real Estate Professional Status is heavily litigated in tax courts. REPS is a great way to harness the tax code, significantly reduce your tax exposure, and save enough to fuel your next investment. Once you qualify, you’ll realize how powerful it is on your journey to financial freedom and building generational wealth.