There are multiple benefits of investing in real estate. Whether it’s generating stable cash flow, the ability to drive appreciation, hedging your portfolio against inflation, or using leverage to increase returns, real estate has been one of the top asset classes to invest in. One thing that attracts savvy investors to real estate is the ability to qualify as a real estate professional.
Two Main Qualifications To Become A Real Estate Professional
From an IRS standpoint, there are several qualifications that must be met in order to achieve a full-time real estate professional status (REPS). However, there are two important qualifications that are usually the biggest hurdles to being able to claim REPS.
- The first is that more than 50% of the personal services you perform during the year must be in a real estate trade or business that you materially participate in.
- It’s important to remember that this is why limited partnerships don’t qualify for full-time real estate professional status. Limited partners don’t have any liability in the business or any managerial responsibilities or voting rights. This is why they are not considered materially participating.
- The second is, during the year, you must work at least 750 hours in a real estate trade or business
- Although 750 hours sounds a lot, it’s actually fairly easy to achieve if you have active or passively active real estate investments.
What Are The Advantages Of Being A Real Estate Professional
The advantages of full-time real estate professional status (REPS) are vast. One of the biggest benefits is the tax advantage of being able to offset your active income with passive losses. The real estate professional status allows you to deduct passive losses against your (and your spouse’s) W-2 income on your tax returns. In short, it can lead to offset most, if not all, of your active W-2 income to where you may never have to pay federal income tax again.
How exactly do you offset your active income with passive losses?
When you qualify for real estate professional status (REPS), you’ll be able to accelerate the depreciation of your assets through a cost segregation analysis on your investment properties. You can then use the “paper” losses generated by accelerating depreciation to offset any other active income that you or your spouse may have. This is pretty powerful because you can not only offset your W-2 income but also any other active business income you have.
Now, I always learn best from examples so let’s walk through one…
The Power Of REPS
For our example, let’s say you’re a full-time real estate professional and your spouse is a physician with an income of $400K a year.
You own an apartment complex that’s managed by a third party and you decide to do a cost segregation study on the asset. For clarification, you’re still considered active in the business since you’re the asset manager and you have set it up as either a general partnership or a joint venture. Having property managers doesn’t preclude you from real estate professional status.
Most apartment complexes are depreciated over 27 years and a cost segregation study accelerates that depreciation on a one, five, and twelve-year schedule. Generally, you’ll get 25% to 30% of the value of the apartment complex depreciated in that first year or at least through 2022 when 100% bonus depreciation is still in effect.
To keep the math simple, we’ll say the apartment complex is worth $2 million. You would get $400K of accelerated depreciation to take in year one.
By qualifying and claiming REPS on your tax return, you’re able to offset your spouse’s income dollar for dollar to where the effective taxable income is now $0.
In other words, because you have real estate professional status and you have $400K of accelerated depreciation, you’re able to completely offset the tax burden of your spouse’s active W-2 income. Consequently, all the federal income tax paid during the year will come back to your spouse in the form of a tax refund.
To clarify, this is not a loophole or cheating the system. It’s an intentional incentive from our government.
Our government wants us to do the jobs they don’t want to do. For instance, they don’t want to be in the housing business or in the oil and gas industry, or in green energy. As a result, they offer us many, many tax incentives in the hopes that we will engage in these activities. This is also a big reason why the real estate industry has so many great tax incentives.
The Road To Financial Freedom Starts Here
If you’re new to real estate investing or you’ve been searching for investment strategies to put you on a path toward financial freedom, it’s very likely you have a ton of questions and uncertainties.
What advantages and risks are there in real estate? What makes an area a good place to invest in real estate? How do you find a good property management company?
These are just some of the questions that tend to come up frequently in my conversations with colleagues.
One of the best methods for getting started, and one I highly recommend starting with, is to read and learn as much as possible. Now, there is a ton of information out there and while some are reliable, there’s still a lot of misinformation out there too.
To get the honest answers that you’re looking for without having to spend a ton of time searching for them, the best place to start is with my ebook!
My new ebook, An Inside Look For the Busy Physician: Top 6 FAQs On Real Estate Investing, will be available soon so stay tuned for updates on how and when you can grab your personal copy for FREE!
In the meantime, if you have any questions or would like to learn more about how you can achieve real estate professional status or other tax advantage strategies, Click Here to schedule a free call with me!
Are you ready to start your financial freedom journey?