- The IRS allows real estate professionals to take certain tax deductions against their income
- Assuming you satisfy the participation and time requirements, there are significant savings available for real estate investors who plan it right
- Navigating the requirements is challenging, and working with an advisor well-versed in real estate is crucial to capturing the biggest tax savings
There are so many seemingly hidden ways to save on taxes in the real estate market. By meeting two key requirements and with an understanding of the rules, high-income investors can reap big savings each year on their taxes. The “Real Estate Professional Status (REPS)” opens the door to being able to reduce taxable income and make the most of rental properties and other work in the real estate industry. It’s not unusual to reduce tax liability by upwards of 20% using the strategies we’ll outline.
Real Estate Professional Status
Let’s run through the benefits and mention what to look out for. You might find that this is right up your alley if you have some experience in the field but have not yet taken on professional work. What’s more, there are methods by which you can snatch tax breaks in prior years. Do I have you curious?
Perhaps most importantly, we need to lay the ground rules. To qualify as a “real estate professional,” you must satisfy two primary annual criteria set forth by the IRS (If you file taxes jointly, then just one spouse must meet the requirements):
1) Material Participation: This means you must be able to prove that you are involved in real estate investments or related activities on a day-to-day basis. Clients we help commonly own a few rental properties, but there are other ways to meet the requirement per the IRS-mandated rules that define Material Participation.
2) Time Threshold: You must also perform more than 750 hours, at least 50% of total time, of real estate services during the tax year in which you materially participated, regardless of if you hold a real estate license. It is imperative that you keep detailed records of your activities should the IRS come a-callin’.
These are murky definitions, but if you work in property development, construction, real estate transactions (like acquisitions), rental property management, or in leasing, then there’s a good chance you can earn REPS status. If, however, you have a full-time job in another field, it will be hard to qualify, though it’s not impossible. One way to go about meeting the time benchmarks is to consider all real estate assets as a single activity for recordkeeping purposes – this is called the aggregation method. We can sit down with you to determine the best method for your situation.
Passive Versus Active Income
Now, it is important to know the difference between passive and active income. It is the latter that features the tax benefits for REPS. Passive income is what it sounds like – money earned without working for it. Active income comes from a job. A real estate professional is allowed to deduct all their rental losses against active income, thereby reducing their overall tax bill. While a taxpayer may only use passive losses to offset earnings from passive activity, a real estate professional may turn passive losses into deductible ordinary losses.
The Value of Depreciation and Amortization Expensing
Moreover, a real estate pro can deduct depreciation as an expense over a property’s useful life which also brings down your taxable income. While land does not depreciate, the tangible assets on the land will likely lose value over time.
A property owner may elect either straight-line depreciation or accelerated depreciation. In general, taking accelerated depreciation maximizes your tax benefit in the earlier years while straight-line depreciation spreads out the expense evenly over time.
Amortization works like depreciation, but it’s the term used for intangible assets such as services and other costs required to transact real estate (amortization depreciation is done strictly with the straight-line method).
Does A Landlord Qualify for the Special Tax Treatment?
We commonly get asked if being a landlord gets you REPS status. The answer is: it depends. Landlords must meet the requirements outlined. If they don’t, then they are considered either a passive or active investor, and the tax rules are less favorable, but there are still benefits to know about.
Crunching the Numbers
After grasping the rules and being intrigued by the tax benefits, let’s run through an example of how being a real estate professional can save you on the bottom line. Consider this hypothetical:
- You purchase real estate for $300,000 with $15,000 of closing costs and a 15-year fixed-rate mortgage
- The composition of that property is $30,000 land and $270,000 is the assumed value of the building
- You fix up the building with another $90,000 of capital
The actual cost of the building is $270,000 and you are then able to claim depreciation on that over 27.5 years, per IRS rules. That amounts to a deduction of $9,818 annually using the straight-line method. The $90,000 of capital improvements are allowed to be depreciated over just 15 years – that’s another $6,000 of annual depreciation expense. Closing costs are amortized over 15 years, so tack on another $1,000.
Total depreciation expense is $9,818 + $6,000 + $1,000 = $16,818.
If you are in the 35% tax bracket, that’s nearly $6,000 of savings. The accelerated depreciation method would result in deducting the entire $90,000 of capital improvement expense in the first year. That could be the optimal strategy if you expect to be in a lower tax bracket in the out years. Either way, you can substantially bring down your taxes owed by taking passive rental losses against non-passive earnings along with marking depreciation expenses.
Real estate professionals may also deduct expenses related to other activities such as management fees, ongoing maintenance, property taxes, and travel costs. Finally, electing the “real estate professional” status on your tax form is simple – just check the box!
The Bottom Line
If you have a significant portfolio of real estate assets, it’s wise to look into acquiring real estate professional status. There are tax benefits that allow REPS to take depreciation expense deductions off their active income.
