The IRS Real Estate Professional: Beyond the Basics

As a recap from our previous blog posts, the IRS defines a real estate professional as someone who spends more than 50% of their working hours and over 750 hours annually in real property trades or businesses where they materially participate.

Therefore, if you are working a full time W2 job, it is extremely unlikely you will be able to qualify unless you have a spouse that does not have a full time job! The tax court cases that we have analyzed consistently show the IRS will and does audit W2 taxpayers who try to claim this tax status.

What is Material Participation?

Material participation is a crucial component. The IRS has seven tests for material participation (Treasury Regulation Section 1.469-5T). Satisfying any one of these tests in a tax year qualifies:

1. More than 500 hours of participation in the activity.
2. The individual’s participation constitutes substantially all of the participation in the activity.
3. Participation exceeds 100 hours, and no other individual participated more.
4. The activity is a significant participation activity, and the sum of such activities exceeds 500 hours.
5. Material participation in any five of the prior ten tax years.
6. Material participation in a personal service activity in any three prior tax years.
7. Based on all facts and circumstances, participation exceeds 100 hours, and the individual was involved on a regular, continuous, and substantial basis.

Real Property Trade or Business

Not all real estate activities are equal. According to IRC Section 469(c)(7)(C), real property trades or businesses include development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

What does qualify? Simply working a W2 job in real estate since you MUST have a 5% or greater equity stake in the activity.

Misconception 1: REP Status Guarantees Active Loss Classification

There is a belief that qualifying as a REP automatically converts all rental losses to non-passive, allowing you to offset other income. In reality, each property must meet the material participation standard unless you make an election to aggregate all rental activities into a single activity. Missing the grouping election will likely cause you thousands in tax and inhibit your overall tax strategy on the way to tax-free wealth.

Misconception 2: Meeting the Criteria Once is Sufficient

Some investors think that once they qualify for REP status, they don’t have to meet the criteria in subsequent years.

However, REP status is evaluated on a yearly basis. Failing to meet the criteria in a subsequent year could revoke the REP status for that year.

Misconception 3: Self-Reporting Without Documentation is Sufficient

Many investors are under the false impression that merely reporting their hours and activities on their tax returns is sufficient. In reality, the IRS can be stringent in auditing REP claims. It’s essential to maintain thorough documentation, including logs, calendars, and records, to substantiate your claims.

At Anomaly, we provide our Concierge Tax clients with self built trackers that we developed after working through IRS audits and using the IRS audit guide.

‍Questions?  Reach out to our tax of real estate tax strategists today and unlock this key to tax-free wealth!