Real estate investing has always been one of the most effective ways to get tax deductions. Unlike other types of investments, the tax benefits that real estate offers are quite diverse. Having said that, it is important to note that benefiting from all these tax advantages requires meeting certain conditions. The most crucial of which is becoming a real estate professional under IRS rules. In this article, we will explain how you can professionalize your real estate business so that you can benefit from every tax deduction that is available to real estate investors.
Related: Real Estate Taxes: Everything a Beginner Investor Needs to Know
The Tax Benefits of Real Estate Investing
Before explaining how you can qualify as a real estate professional, we must first go over the tax implications of real estate investments. Here is a brief overview of how real estate taxes work.
1- Depreciation on rental property
As is the case with any asset, your investment property will depreciate over the years. Real estate investors get tax deductions on this depreciation. What makes this tax deduction so advantageous is the fact that you are able to reduce your tax bill all the while the value of your investment property soars through appreciation.
Related: Here’s How to Calculate Depreciation on Rental Property
2- Low capital gains on long-term investments
Buying rental properties as part of a long-term rental strategy comes with many tax benefits. Chiefly among them is the low capital gains taxes that you will have to pay. Any profit you make from the investments will be taxed at as low as 0% for the lowest income bracket.
3- No income tax
One of the best things about investing in real estate is the income tax exemption. As a matter of fact, the IRS does not classify real estate investments as income-generating businesses. Consequently, the income you earn from them is not subject to taxation. However, there is one exception to this. Property investors who receive a salary through a holding company will have to pay taxes on that income.
4- 1031 exchange
Real estate offers investors the option of deferring taxes through an instrument called 1031 exchange. In other words, real estate investors are able to defer profits from an income property when investing in another property of comparable value.
5- Loss deduction
One of the perks of becoming a real estate professional is the ability to deduct all losses against ordinary income. Investors who own multiple rental propertieswill be able to deduct thousands of dollars at the end of the year. A 100% tax deduction can lead to zero tax liability.
Let’s now delve into the ins and outs of qualifying for real estate professional status.
How to Become a Real Estate Professional
The first question any novice real estate investor would ask is “What is a real estate professional for tax purposes?” In simple terms, a real estate professional is an individual who makes a living buying, selling, or managing investment properties. However, the IRS real estate professional definition is more specific in terms of what constitutes a professional. There are three main criteria that property investors have to meet:
- The taxpayer has to materially participate in a real estate trade.
- More than half of the taxpayer’s yearly services and activities were performed in their real estate business.
- The taxpayer should spend at least 750 hours during the year selling, buying, and managing income properties.
It’s also worth noting that the IRS does not have a list of specific jobs that qualify for pro status. As long as you meet these criteria, you’re considered a real estate professional.
The Steps to Obtaining Professional Status
Becoming a professional is predicated on abiding by a number of real estate professional rules. Moreover, taxpayers have to meet these rules on a yearly basis if they don’t want the IRS to revoke their status. In any case, here is a brief overview of some of the simple steps that you should follow.
1- Identify the nature of your real estate businesses
The first step of embarking on a professional real estate career is to identify the exact nature of your real estate businesses. It’s important to note that not all real estate trades are included in the statute. In order to qualify as a real estate professional, your real estate business has to fall under one of these categories:
- Real property development
- Redevelopment
- Construction and reconstruction
- Acquisition
- Conversion
- Rental
- Operation
- Management
- Leasing
- Brokerage
2- Ensure material participation in the business
Making sure that you can prove material participation in a real estate trade is critical when applying for pro status. The IRS has a specific set of criteria when it comes to determining the extent of your participation. Here are some of the criteria that can help you prove material participation:
- The taxpayer has more than 500 hours of active participation in the business during the tax year.
- The taxpayer’s activity during the tax year is no less than the participation of any other individual.
- The taxpayer has participated in the business for 5 of the past 10 years.
3- Make sure that you have enough hours for professional status
After identifying all your hours of material participation, the next step is to determine whether or not you have enough hours to qualify for real estate professional status. Like we mentioned earlier, the minimum number of hours is 750. You also need to prove that over half of your service hours have been performed in a real estate trade.
4- Convert your activities from passive to non-passive
If you have satisfied the requirements of the previous steps, then you are able to qualify as a real estate professional. Having said that, unlocking all real estate professional tax benefits does require an extra step. A good example of this is the real estate professional exception to the passive activity rules. Generally, investors are not allowed to offset the losses from a passive activity against an income from a non-passive activity. However, the real estate professional exception allows taxpayers to bypass this rule by enabling them to convert their activities from passive to non-passive. Taxpayers can benefit from this exception by establishing material participation in each rental activity.
The Bottom Line on Qualifying as a Real Estate Professional
As is the case with most legal aspects of real estate, qualifying as a real estate professional can be a complex process. Consider retaining the services of a tax consultant who can guide you through it and explain all the options that are available to you. In the meantime, you can start looking for rental properties right here! Use our Property Finder to identify the perfect property for your needs and check out the Mashvisor Property Marketplace to search for undervalued off-market properties.
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