Qualifying as a real estate professional can allow rental real estate losses to be treated as nonpassive for federal tax purposes when you also materially participate in the rental activity. That can make losses available to offset other nonpassive income, subject to other applicable tax limitations.
Qualifying takes more than simply owning or managing rental properties. The IRS looks closely at hours worked, the nature of your real estate activities, and your level of participation. Careful documentation is therefore an important part of establishing real estate professional status.
What Does Real Estate Professional Status Change on Your Federal Return?
Rental real estate is generally treated as a passive activity for federal tax purposes. That means rental losses generally offset passive income, with unused losses potentially carried forward to future years.
For taxpayers who qualify as real estate professionals, rental real estate activities in which they materially participate may instead be treated as nonpassive. This can make qualifying losses available against other nonpassive income, although basis, at-risk, and other tax limitations may still apply.
Qualifying may also affect whether rental income is subject to the 3.8% Net Investment Income Tax, depending on material participation and the specific facts surrounding the activity.
Suspended passive losses from prior years require additional attention. Qualifying as a real estate professional in the current year does not automatically make all prior suspended passive losses deductible. Former passive activities are subject to separate rules that determine when previously suspended losses can be used.
Qualification and Hours
To qualify as a real estate professional for federal tax purposes, you generally must satisfy two tests during the tax year:
- More-than-half test: More than half of the personal services you perform in all trades or businesses during the year must be performed in real property trades or businesses in which you materially participate.
- 750-hour test: You must perform more than 750 hours of services during the year in real property trades or businesses in which you materially participate.
Qualifying real property trades or businesses can include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and brokerage.
Employee hours generally count only if you own more than 5% of the employer.
For married taxpayers filing jointly, one spouse must independently satisfy both real estate professional tests. You cannot combine spouses’ hours to reach the more-than-half or 750-hour requirements.
However, the rules change when determining material participation in a particular rental activity. For that test, your spouse’s participation generally can be counted, even if your spouse does not own an interest in the property.
Keeping detailed records of your participation is important. The IRS allows taxpayers to establish participation through reasonable methods, but contemporaneous calendars, time logs, appointment records, and similar documentation can provide stronger support than trying to reconstruct activity after questions arise.
Does Clearing the Hours Finish the Job?
No. Qualifying as a real estate professional is only the first step. You must also materially participate in the rental activity for it to be treated as nonpassive for federal tax purposes.
The IRS provides seven tests for material participation. Some of the most commonly applicable include:
- 500-hour test: You participate in the activity for more than 500 hours during the year.
- Substantially all test: Your participation constitutes substantially all participation in the activity by everyone involved, including individuals who do not own an interest.
- 100-hour test: You participate for more than 100 hours during the year and at least as much as any other individual.
Other material participation tests may also apply depending on the circumstances.
Owners with multiple rental properties face another challenge. For federal purposes, each rental real estate interest is generally treated as a separate activity when evaluating material participation.
A qualifying real estate professional can elect to treat all rental real estate interests as one activity. This can allow participation to be evaluated across the combined rental portfolio instead of separately for each property.
The election should be considered carefully. Once made, it generally remains binding for later years in which you qualify as a real estate professional and can generally be revoked only after a material change in facts and circumstances.
Filing the Federal Return
Real estate professional status changes how qualifying rental activity is characterized for federal tax purposes, but it does not change where rental income and expenses are generally reported.
Rental real estate income and expenses typically remain on Schedule E. If you qualify as a real estate professional and materially participate in a rental activity, that activity may be reported as nonpassive rather than being subject to the usual passive activity loss limitations.
If you have multiple rental properties and choose to treat all rental real estate interests as one activity, the federal aggregation election generally requires a statement with the original return for the year the election is made. Certain taxpayers who miss the original deadline may qualify for late-election relief.
Accurate reporting is particularly important because real estate professional status, material participation, prior-year suspended losses, and aggregation elections can all affect how rental losses are treated.
How Does California Handle Real Estate Professional Status?
California treatment is significantly different from federal treatment.
California does not conform to the federal real estate professional exception under Internal Revenue Code Section 469(c)(7). For California purposes, rental activities generally remain passive even when the same rental activity qualifies as nonpassive on the taxpayer’s federal return.
This can create an important difference between federal and California taxable income. A rental loss that may be available against nonpassive income on the federal return may remain subject to California’s passive activity loss limitations.
Form FTB 3801 is used to calculate California passive activity loss limitations and adjustments when California’s treatment differs from federal treatment.
California also does not recognize the federal election under IRC Section 469(c)(7) to treat all rental real estate interests as one activity. For California purposes, taxpayers group rental activities without regard to that federal election.
Depreciation can create additional differences between the federal and California returns because California does not conform to certain federal depreciation provisions. Depending on the circumstances, additional California adjustments may therefore be required.
For investors with multiple properties, these federal and California differences can result in substantially different loss calculations between the two returns.
Put Your Hours and Records in Order This Year
Real estate professional status can provide meaningful federal tax treatment for qualifying investors, but the rules involve more than simply reaching 750 hours. Qualification, material participation, documentation, prior passive losses, aggregation elections, and California’s separate treatment all need to be considered.
Robert Hall & Associates has worked with real estate investors throughout Los Angeles, Orange County, and across California for more than five decades. Our tax professionals help clients maintain documentation, evaluate qualification requirements, and properly report rental activity under both federal and California tax rules. If you own rental real estate and want to understand whether real estate professional status may apply to your situation, ask about a complimentary discovery call or contact Robert Hall & Associates to get started.
