For many rental property owners and real estate investors, “real estate professional” is not just a job title, but a specific tax status designated by the IRS under IRC §469(c)(7). Real estate professional (REP) tax status recharacterizes rental activities from passive to non-passive. This recharacterization can provide significant tax benefits by allowing qualified individuals to avoid Passive Activity Loss (PAL) limitations on net rental losses, avoid 3.8% Net Investment Income Tax (NIIT) on net rental income, and potentially offset net rental losses against other income, such as W-2 and business income. This article will walk through the various requirements and nuances to qualify as a REP.
To qualify for REP status, you must meet the following tests and criteria: 50% test, 750 hour test, and material participation
50% Test
- More than 50% of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- A real property trade or business is defined by the IRS in §469(c)(7)(C) as a trade or business that does any of the following with real property: development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
750 Hour Test
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
Material Participation
- Material participation requires an individual to be involved in operations of an activity on a basis that is regular, continuous, and substantial. Material participation is satisfied by meeting at least one of the seven tests provided by the IRS in Pub. 925. The first and most commonly met material participation test is participating in the activity for more than 500 hours in a tax year.
- It is common that by satisfying the 750 hour test, you also satisfy the material participation test, as the same hours that satisfy the 750 hour test may also satisfy the 500 hour material participation test. However, this is not always the case and depends on the nature of the work performed. Hours required to satisfy material participation must be spent directly on the rental activity, as the IRS is testing material participation in that particular rental activity. Hours required to satisfy the 750 hour test may be spent on any real property trade or business, as the IRS is testing that you are actively involved in the real estate profession overall.
- If you file a joint return, don’t count your spouse’s personal services to determine whether you met the 50% test or 750 hour test. However, according to §469(h)(5), you can count your spouse’s participation in the rental activity in determining if you materially participated. This means that even if you have met the 750 hour test by participating in real property trades or
businesses overall, you may not have met the material participation requirement for your rental activity. This is where your spouse’s participation in that particular rental activity can count towards your material participation hour requirements.
Grouping
Each interest you have in a rental real estate activity or property is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity by grouping them. For taxpayers with multiple rental activities, it is likely difficult to meet the material participation test for each property separately, so it is common to group rental activities. In order to group multiple rental activities together, those activities must form an appropriate economic unit for measuring gain or loss. IRS Pub. 925 states factors of multiple activities that show an appropriate economic unit include a similar type of trade or business, common control, common ownership, geographic location, or interdependencies among the activities.
Record Keeping
In order to meet these qualifications, it requires meticulous documentation and record-keeping. Developing and maintaining a credible and detailed log of your daily real estate activities is essential. This can be a log including the nature of the real estate work performed, dates, hours, and supporting documentation: such as receipts, email/call records, credit card charges, bank statements, records of appointments, and more.
Article by: Kristen Kauhane, CPA
