More and more Americans are considering the idea of real estate as a way in which to generate passive income. Rental income, or gains from the resale of property, can generate a nice income. However, a lot of people fail to think about the tax obligations related to these activities.
The IRS allows some real estate taxpayers to register as a real estate professional with the IRS. This status allows taxpayers to claim or deduct real estate losses against nonpassive income (e.g., income from work).
In this article, we are going to discuss what a real estate professional is. We also want to touch upon how you can be classified as one by the IRS. As with most tax laws, things can get rather complicated. We are confident that you will leave this page with a much better understanding of tax as a real estate professional is.
What Is a Real Estate Professional?
There are two main types of income that you must declare to the IRS:
- Passive income
- Nonpassive income
Passive income includes all forms of income that you are not actively working for. This may mean interest on investments or even rent from properties that you own. Nonpassive income covers everything that you need to actively put effort into. This may include jobs that you carry out or even items that you sell online.
In the eyes of the law, any losses from passive income cannot be claimed against nonpassive income. This means that any losses that you make owning real estate will not reduce your tax bill.
That is how it generally works. However, those that own property as a way of making money can potentially register as a real estate professional.
As a real estate professional, you can offset any passive income losses (related to your properties) against your nonpassive income. This means that if you have a particularly tough year in real estate, you may be able to enjoy a lower tax bill.
How Do You Become a Real Estate Professional?
This is where things can become somewhat confusing. Owning a property for passive income purposes is not enough to qualify as a real estate professional. To qualify as a real estate professional, you must be able to prove to the IRS that you should be classified as one. When IRS is looking to determine your status, they will carry out three tests.
You must document all activities related to your business if you wish to pass these tests. The IRS, as you know, aren’t huge fans of people paying less tax than they should. This means that they are going to look at you with a great deal of scrutiny.
Test One: You Should Be Working on Real Estate More Than 50% of Your Working Time
Your real estate business cannot be considered a side business. Most of your working hours need to be dedicated to working in your real estate business. It needs to be your life.
If you work a full-time job, chances are that you won’t be able to qualify as a real estate professional.
Test Two: You Must Work More Than 750-Hours Per Year on Real Estate
To class yourself as a real estate professional during tax season, you must work at least 750-hours per year on your real estate business. This can be anything related to your business e.g., property management, purchasing a new property, carrying out construction, etc.
There is no requirement for these 750-hours to be spread throughout the year. You can work all of these hours in the first part of the year and then take a few months off if you wish. If you are not working a job that can push you under the 50% real estate mark, then you should be fine.
Keep a log of everything that you work on with your real estate business.
Test Three: It Must Be Material Participation
In most cases, the third test is going to be moot. This is because if you pass test two, you will automatically pass test three. This is because the IRS defines material participation as being more than 500 hours working on a real estate business per year. However, this participation must be carried out on a regular, continual basis.
Other criteria can be met here. However, this can be a bit more complicated. For now, just assume that if you meet the first two tests, then you should be fine.
Declaring You Are a Real Estate Professional
If you believe that you will qualify as a real estate professional, then you can tell the IRS. However, they will require documentation from you. This includes:
- Details of work you carried out related to your business.
- A log of any hours that you worked on your real estate business
- Times and dates that the work was carried out
While it is always good to be as accurate as possible with any information that you submit to the IRS, they can accept estimated hours for some projects. These hours must be reasonable, though. You can’t declare that it took you 24-hours to fit a door, for example. It is a project that would take no more than an hour or two.
If the IRS classes you as a real estate professional, then you will be able to start claiming passive income losses (including property depreciation) against your nonpassive income.