How to Qualify for Real Estate Professional Tax Status (Full Guide)

The real estate professional tax status changes your rental income from passive to ordinary income.

Qualifying for this status is the gateway to substantial tax savings for many real estate investors.

And fortunately, to qualify for this license, you do not need a formal license.

You do not have to be a real estate agent, broker, or anything like that to qualify for the IRS’s definition of a real estate professional.

All you need to do is to meet two specific IRS requirements, which will be detailed in this post.

The Main Obstacle to Using Rentals to Reduce Your Taxes

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Normally, high-income taxpayers want to use rental properties to reduce their taxes. 

This is because the tax law allows real estate investors to take large depreciation deductions on their tax returns.

Depreciation is a non-cash expense that you can claim on your tax return. 

In addition to this, the tax law permits real estate investors to increase their depreciation deductions with a cost segregation study.

Taking all of this depreciation usually results in a tax loss on paper for most real estate investors. 

This tax loss is what they want to use to offset other income sources on their tax return to pay less taxes overall.

However, they run into an obstacle called the Passive Activity Loss Limitations. 

Basically, rental income from real estate is considered passive income.

And the IRS says passive losses that exceed passive income are not allowed to be deducted. 

This poses an issue for investors with real estate losses and no passive income to offset it with.

Most would prefer to use those losses against their W2 or business income.

But income from your job (W-2) or business is considered earned (ordinary) income. 

The IRS treats these two types differently – you cannot use passive rental losses to offset your earned income.

So what can you do about this? 

There is one solution – qualify as a real estate professional. 

The IRS says that if you qualify as a real estate professional, your rental activities in which you materially participate are not passive activities. 

This lets you take your rental losses and use them to offset your W-2 and business income that year.

What is a Real Estate Professional and How Do You Qualify?

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A Real Estate Professional is simply a tax status you can qualify for. 

To get this status, you need to meet two requirements:

1. More than half of all of the personal services you perform in all trade or businesses must be performed in rental properties where you materially participate.

2. You must have worked at least 750 hours during the tax year on the rental properties you materially participated in.

If you meet those two tests, you qualify as a real estate professional. 

If you can’t meet those requirements, there are a couple of workarounds:

Workaround #1: Qualifying with a Spouse

Many investors have high-income day jobs and businesses they operate on a day-to-day. Because of this, they cannot qualify as a real estate professional themselves.

A popular workaround to qualify for this status is through their spouse opting for this status.

If your spouse qualifies and you file a joint return with him or her, you could use your rental losses to offset your earned income.

Workaround #2: Short-term Rentals

Another option is using a short-term rental strategy. With this strategy, you do not need to qualify as a real estate professional.

This is because short-term rentals are not subject to passive activity loss rules.

The IRS says your activity is not a rental property if any of the following apply:

1. Customers use your property for an average of 7 days or less.
2. If your customers’ average use is 30 days or less and you provide significant personal services with the rentals.

With short-term rentals like Airbnbs, losses are not subject to passive activity loss rules.

Therefore, the real estate professional tax status would not be needed.

Workaround #3: Special Allowance for Passive Losses

Another alternative to becoming a real estate professional is to use the special allowance for passive losses.

The IRS grants a $25,000 “Special Allowance” for passive losses if you or your spouse actively participated in a passive rental real estate activity.

Unlike the Real Estate Professional route, no hour requirements exist. 

Just active involvement in management.

However, the $25,000 allowance only applies to those earning under $150,000 in adjusted gross income (AGI).

So with incomes below $150,000, you can deduct up to $25,000 in rental real estate losses against your ordinary income without any other qualifications.

In summary, you can bypass the passive loss limitations by getting classified as a real estate professional yourself, having your spouse get that status, opting for a short-term rental strategy, or qualifying for the special allowance granted by the IRS.

Bottom Line

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Qualifying as a real estate professional can provide substantial tax benefits that shouldn’t be overlooked by rental property owners. 

While meeting the IRS requirements may seem challenging, the potential rewards make it well worth exploring all viable strategies. 

Regardless of your approach, conduct careful tax planning and receive guidance from a qualified tax CPA.

This ensures you follow the rules and get the maximum benefits. 

With hard work and the right strategies, real estate professional status could be the key to growing your wealth over many years.