TBT: Ask Marco – Qualifying for Real Estate Professional Status

Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.

Today’s question comes from Kelliane, and she says, hi Marco. I just recently discovered your podcast and have been binge-listening. Thanks for the great content. I am an attorney turned entrepreneur who recently sold my eCommerce business. My husband is in medical device sales with a high W2 income. I am now launching a new consulting business and podcast. My husband and I are trying to also ramp up our real estate investing business. After exploring many options. We are most interested in passive real estate investing example, acquiring turnkey, single and multifamily, multifamily, syndications, and hard money lending. We are working diligently to do everything we can to create a passive income, minimize taxes, and achieve financial freedom within the next five to seven years.

Great goal and congratulations on all that.

Because of my husband’s high W2 income, I would love to be able to qualify as a real estate professional to take advantage of the tax benefits. However, I don’t see how this is possible. If we were to pursue the passive real estate investing strategies as mentioned above, do you have any insight as to how we can get the best of both worlds? Thanks, Kelliane.

——————————————————————————————————————————————

Throwback Thursday Episode (The episode originally took place in the year 2020)

This episode is part of our Throwback Series and may include references to older content such as webclasses, events, promotions, or links that are no longer active or available. While the conversation and insights still hold value, please note that some information may be outdated.

Download your FREE copy of The Ultimate Guide to Passive Real Estate Investing.

If you missed our last episode, be sure to listen to From 9-5 Stress to Passive Income Success (Adam’s Story)

 See our available Turnkey Cash-Flow Rental Properties.

SUBSCRIBE on iTunes

Well, Kelliane, thanks for submitting your question. And this is a great question because we are all interested in building a business and, or increasing our income, lowering our taxes, or keeping them under control and of course, achieving financial freedom within the timeframe that we set out to do it. And so this is all great. Now let me begin by first of all, giving you a disclaimer, and I’m going to probably mention again later, I am not a tax advisor or a tax professional, and I don’t give out financial advice. So I’m going to give you some perspective and commentary that will at least help put this together for you in your mind and get you on the right track. But ultimately I think you’re going to have to consult with a good tax professional that is knowledgeable on the real estate professional classification. But let’s talk about that first because maybe you won’t even get that far and there are pros and cons and you’ll understand why I say that.

So let me, first of all, begin by saying that we all know real estate has an amazing ability to potentially provide tax losses and deductions with tax-free cashflow real estate is one of those investment vehicles where you can actually show a loss on paper, what we call a paper loss, but still have positive cash flow that flows into your pocket. But these deductions, sometimes they’re not completely used. And the question that you’re asking is how can we take maximum use of these deductions, these passive losses and apply them to all of your income, not just passive income, but active income.

I believe that’s the direction you’re going with this because your husband has a high income. And so you have high household income. Let’s also start off by saying this for those people who are not clear on what a real estate professional classification or status is as a real estate professional, you are able to deduct 100% of your rental depreciation and your quote-unquote losses against any other type of income, whether it be ordinary income or passive income. And you do this all on the front page of your 1040 IRS tax form. So it’s a beautiful thing. If you qualify for it, when you can take all of your passive losses, even those losses that are just paper losses on paper, they’re not necessarily realized the losses that you actually take as a loss, and you can flow that onto your tax return and take that as a deduction against your income, all income, including ordinary income. That is the goal. The main benefit of being a real estate professional and qualifying for the real estate professional classification.

Now the IRS classifies real estate investors into three classifications. And the first classification is what is known as a passive investor. Now, this classification is the least beneficial category of the three, but it allows you as the taxpayer, the ability to deduct those passive losses against your passive gains, pretty straight math. It’s the most simple of the classifications. The second one is when you’re classified as an active investor, and this classification allows you as a taxpayer to deduct an extra $25,000 of losses against ordinary income. So it’s $25,000 that you can just write off from any ordinary income, like your husband’s W2 income. However, this deduction, unfortunately, phases out completely as your AGI or your adjusted gross income is above $150,000 for a married couple or a hundred thousand dollars for a single individual. So depending on how you file, it will ultimately phase out completely. Once you pass that $150,000 threshold as a married couple filing jointly. So you can lose this pretty quickly. And my guess is based on what you’re saying, your husband’s W2 income is above 150,000. So this wouldn’t necessarily apply to you. The third classification is what you’re talking about or asking about, and that is the real estate professional classification. Now, this classification will allow you to deduct a hundred percent of all your real estate losses against ordinary income. And that’s a great thing because if you have a lot in terms of deductions from your not just real estate, but any investment that carries passive losses, you can apply that to all of your income, not just passive income now, by taking this deduction or classification and making that election. It’s a checkbox.

A lot of people end up creating literally thousands of dollars in tax deductions resulting in a zero tax liability at the end of the year. And you don’t have to have a lot of rental properties to do this. A handful or even two or three can provide you with thousands of dollars of deductions. Now here’s where it gets a little tricky to qualify as a professional for tax purposes. You, the taxpayer or your spouse need to meet a two-part test. Number one, you must spend the majority of your time in your real estate business. Number two, you, the taxpayer needs to spend a minimum of 750 hours per year or more in your real estate business or real estate management part of your business, either one. So you must materially participate in that business with a total of 750 hours or more in order to be able to qualify.

And this is a very hard rule that they’re strict about because a lot of people try to take this classification of being a real estate professional in order to get those deductions and apply them to active income, but they don’t actually qualify. So if you were ever checked or audited, you really have to document and clearly, clearly show that you have actually put in that 750 hours or more. And this is where a lot of people don’t have the ability to qualify as a real estate professional. Now, one of the questions that come out of this is what qualifies as a real estate business or a real property business. Well, the IRS doesn’t list the jobs that qualified. They don’t actually have a list that shows what qualifies as that type of business. But if you are working as an entrepreneur in real estate, whether you’re licensed or not, you probably qualify.

And again, this is where I suggest you talk to a seasoned and knowledgeable tax advisor or tax professional because there’s going to be some additional questioning and rules that are going to apply to this. Now, the other thing too, is what is material participation? Well, again, this is somewhat a little nebulous because you can actually qualify for material participation in the business under seven different tests with the IRS. So odds are you probably qualify with material participation where I think a lot of people fall short is meeting that 750 hours or more in the real property business in order to be able to qualify, because remember, that’s one of the two key tests that you need to pass in order to get that classification. Now don’t let that get you down because as a side note, this is where I think a lot of people just ultimately choose not to bother.

It’s important to realize that qualifying as a real estate professional doesn’t necessarily fit every taxpayer, whether filing jointly or single, because at the end of the day, all your income will be considered ordinary income subject to self-employment tax. So there are other ways to defer and minimize your taxes in working with a well qualified and knowledgeable tax advisor or tax professional. So there are other ways that you can get around this instead of being a real estate professional, talk to your tax advisor, or maybe we can recommend two or three people for you if you just get in touch with me. But the point here is that when you make this election, all your business income is now considered ordinary income, and that is subject to self-employment tax. Therefore, you probably don’t have a choice, but to create an S Corp an S corporation in almost every situation in order to give you the tool that you need to be able to minimize or eliminate or defer that self-employment tax, the S Corp is really one of the only vehicles that allow you and gives you the flexibility to be able to do that.

So if that is no go for you, then maybe consider other creative options to minimize your taxes instead of becoming a real estate professional. Now, back in February of 2019, I actually did an episode titled huge tax benefits as a real estate professional. It was episode number 130. If you go back and listen to that episode, we get into more detail about the real estate professional classification. But again, the bottom line here is that this is a great option if it fits with what you’re trying to do and what you are capable of doing and willing to do, but there are potentially other creative and legal ways to defer and or minimize your taxes and your tax impact. And again, I’m going to just say it again, in order to discover those creative ways of doing that, you should consult with a good tax professional. Who’s knowledgeable on this classification, as well as asset protection and other ways to structure your entities. So you can minimize and reduce those taxes. So this is not the only way, but it is a good way for those people who do fit inside this box.

And lastly, my final comment is to make sure that you sit down and pencil out the numbers and just see what the actual tax may be on your tax return by claiming to be a real estate professional for tax purposes, because it may not be what you expect it to be, and it may not pan out to be what you hope it to be. So again, just consult with your personal tax advisor or consultant who’s knowledgeable in this area, and they will help you to map this out and pencil out those numbers. It’s not that complicated, but it’s also not completely simple because it’s gonna really depend on what your overall situation is and what you have going on.

Okay. So I hope that helps. And again, Kelliann, I appreciate the question.

I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco. Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.

—————————————————————————————————