Most people think that being classified as a real estate professional for tax purposes is reserved for realtors, agents, brokers, attorneys, investors and other professionals who hold a license or designation. However, this is not always the case. For example, construction contractors, general contractors or subcontractors can also qualify.

Real estate professionals may be able to deduct certain business expenses, losses and property depreciation from their overall taxable income. For example, a real estate professional with a total net income of $275,000 and net rental losses of $175,000 can offset their income with the losses. In this case, they may be able to reduce their adjusted gross income to $100,000.

Qualifications

As explained in IRS Publication 925 (2021), Passive Activity and At-Risk Rules (Cat. No. 64265X), a taxpayer may qualify as a real estate professional for the year if they meet both of the following requirements:

• More than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated.
• The taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which they materially participated.

A closely held corporation could qualify as a real estate professional if more than 50% of the gross receipts for its tax year came from real property trades or businesses in which it materially participated.

The above qualifications typically must be met by each person who wants to receive the real estate professional tax designation. However, there is an exception for married couples filing jointly.

Exceptions

Married taxpayers who file jointly cannot count personal services performed by their spouse to determine if they qualify as a real estate professional. However, they can count their spouse's participation in an activity to determine if they materially participated.

Taxpayers cannot include personal services performed as an employee in real property trades or businesses unless they own 5% or more of the employer's outstanding stock, outstanding voting stock, or capital or profits interest. Other rules apply.

Real Property Trades or Businesses

A real property trade or business must participate in any of the following activities to qualify:

• Develops or redevelops;
• Constructs or reconstructs;
• Acquires;
• Converts;
• Rents or leases;
• Operates or manages; or
• Brokers.

Material Participation

Generally, the IRS considers taxpayers to have materially participated in a real estate investment activity if they were continuously, regularly and substantially involved in its operation during the tax year in question. The IRS has seven qualification criteria to determine if a taxpayer meets the material participation standard.

Taxpayers who file a joint return can count their spouse's participation in an activity to determine if they materially participated. However, they cannot count their spouse's personal services to qualify as a real estate professional.

Passive and Rental Activities

Generally, there are two kinds of passive activities:

1. Trade or business activities in which a taxpayer does not materially participate during the year; and
2. Rental activities conducted by a taxpayer who does not qualify as a real estate tax professional.

A passive activity loss for the tax year is excess passive activity deductions over passive activity gross income.

Rental activities are typically passive activities even if the taxpayer materially participates unless that individual is a qualified real estate professional. An activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income (or expected gross income) from the activity represents amounts paid (or to be paid) for the use of the property. It doesn’t matter whether the use is under a lease, a service contract or another arrangement (exceptions apply).

Special $25,000 Allowance

If a taxpayer or their spouse actively participated in a passive rental real estate activity, the amount of the passive activity loss that’s disallowed is decreased. The taxpayer can deduct up to $25,000 of loss from the activity from nonpassive income. This special allowance is an exception to the general rule. Credits can be offset from the activity against the tax on up to $25,000 of nonpassive income after any losses are allowed under this exception.

Qualifying as a real estate professional benefits taxpayers who want to save money on their taxes. Although the requirements may be strict, individuals who qualify could save a substantial amount. As with everything, it is advisable to do a cost/benefit analysis.