In my article, The Single Best Tax Saving Strategy for High Income Earners I breakdown the exact strategy countless real estate investors use to save hundreds of thousands of dollars each year on their taxes.
A critical piece of the strategy requires you (or your spouse) to qualify as a real estate professional.
Qualifying for real estate professional status “REPS” allows you to take large paper losses from your rental activities and significantly reduce the taxable income derived from non-passive sources (eg. your 9-5 day job).
The result? Massive tax savings. Literally in the hundreds of thousands of dollars.
Most of the content on this topic is written by CPAs.
Don’t get me wrong, I love my CPA. But he isn’t an investor. His job is to get the numbers 100% right. It’s not to distill complex concepts into simple takeaways that matter to us investors.
That’s what I’m here for.
Keep reading if:
- You, or your spouse, do not have a full-time job
- Your household income exceeds $150,000 per year
- You, or your spouse, have 15 hours per week of extra time
- You want to invest (or better yet, already invest) in real estate
- You are sick and tired of paying so much tax! (… aren’t we all …)
Qualifying for Real Estate Professional Status “REPS”
There are two simple tests you must meet in order to qualify as a Real Estate Professional
- You spend more than 750 hours in real estate, AND
- You spend more than half of your time in real estate.
On the surface those two conditions seem pretty straightforward, but like everything with the tax code, the devil is in the details.
I think the simplest approach to is to answer some commonly asked questions:
What hours count toward that 750 minimum?
There is quite a bit of grey when it comes to hours that count toward the 750 minimum.
The specific language the tax code uses to describe a valid activity is any, “development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, or leasing activity.”
Investor activities, time traveling to and from the property and education or research hours are generally not counted toward the 750 minimum.
Again, there is a lot of grey here and you should run the specific details by a knowledgeable CPA. The general litmus test is to ask yourself question: “is this activity something a typical property manager would need to perform if they were operating my property?”
If the answer is yes, you can count those hours.
Or is this activity just a common investor activity (e.g. scanning Zillow for new listings)?
Those hours generally will not count.
Can I have a full-time day job and still qualify for REPS?
If you and your spouse are both working full-time, you will not be able to qualify as a real estate professional. Full stop. Don’t try it.
Since you have a full-time job, the IRS will assume there is no way for you to spend more than 40 hours per week on your real estate activities. That is a major red flag and leaves you at high risk of an audit.
The much more common approach is for the more flexible spouse to qualify as a real estate professional, while the other spouse continues to earn a W2 high income from their day job. As we’ll see later on, that combo is a powerful wealth generator.
If this just isn’t an option for you, check-out the short-term rental loophole.
💡 Pro Tip: If both spouses are working full-time jobs, it may be worth running some quick math on the merits of the lower earning spouse stepping away from their full-time job and pursuing REPS. The quality of life v. post-tax income tradeoff is what matters most.
Can spouses combine their hours to reach the 750 minimum?
In the case of married couples (filing a joint tax return), one spouse must achieve both tests on their own, meaning spouses cannot combine service hours for the purposes of achieving REPS.
You can, however, combine service hours to establish material participation in your rental activities, which I will cover in a minute.
How does the IRS actually track those 750 hours?
It is your responsibility to keep a “contemporaneous log” of your activities.
Each entry should include, at a minimum, the date the activity was performed, a description of the activity, the property affected and the time you spent.
You will not need to provide this worksheet with your annual tax return. In fact, your CPA technically isn’t required to review it (though I would recommend asking for a quick review, especially if it is your first time qualifying for REPS).
The log becomes important if an audit is performed, which is a very unlikely outcome.
But for your peace of mind, and to comply with IRS requirements, I would strongly advise keeping a detailed log of your activities.
Establishing Material Participation
Qualifying as a real estate professional is just the first step.
In order for your passive rental losses to become active, you need to establish material participation in each rental property.
There are 7 super confusing tests the IRS applies to establish material participation. You only need to satisfy 1 of these tests.
Rather than overwhelm you with the details, 2 of the 7 tests will matter for most people (see FAQs for the other tests):
- You participate more than 500 hours in the activity
- You participate 100 hours in the activity AND more than anyone else
I’m sure you’re saying to yourself… wait, what’s the difference between the 750 hours you need to qualify as a real estate professional and the 500 hours you need to establish material participation?
That’s the right question 🙂
In terms of what hours count, there is actually no difference. I explained above what kind of hours count toward your 750 minimum for REPS. Those same hours will count toward your 500 material participation minimum.
However, the key here is that the two material participation conditions must be met for each property with passive losses that you want to convert to active losses.
If you don’t establish material participation at the property level, those losses will remain passive.
So let’s say you own 2 rental properties and you want to take losses from each to offset your active income. If you establish material participation using the first test, you will need to spend 1,000 hours in total (500 hours per property). Since this is greater than 750, you will automatically qualify for REPS in the process. But still, but 1,000 is quite high.
… Now imagine if you had 4 properties…
You see the problem.
The second test of spending at least 100 hours AND more than anyone else is likely the easier path since you need to hit that threshold for each property. Granted you will still need to accumulate 750 total hours in that tax year for the REPS qualification, but we already knew that.
The common exceptions here are if you hire a property manager for one of your properties or are undertaking significant renovations. It’s unlikely in either scenario that you are “participating more than anyone else”.
💡 Pro Tip: For purposes of establishing material participation, spouses hours may be combined. The catch, however, is that a single partner must qualify as a real estate professional standalone (750+ hours). Hours cannot be combined for REPS, only for material participation.
Sec. 1.469-9(g) of the tax code – commonly referred to as the grouping election – allows you to make an election that will combine the hours of each rental property together in order to hit the 500 hour minimum.
If you make this election you will simply need 750 hours combined across your entire portfolio.
This is a very popular election that many real estate professionals will make. A big advantage here is there is no need to “prove” that you participated in each property more than anyone else. That burden of proof can be challenging to meet.
Also, if you make this election and meet REPS, you can include losses from your Limited Partner Investments in Real Estate Syndications. This is a super clever workaround that most CPA’s aren’t familiar with, but should support once they wrap their head around it.
What Comes Next?
Great – you followed the steps above and you qualify as a real estate professional.
You’re probably wondering why that matters.
Again, I’d strongly encourage you read The Single Best Tax Saving Strategy for High Income Earners. There I breakdown the entire strategy qualifying real estate professionals use to save thousands of dollars on their taxes.
The process looks something like this:
- Purchase an investment property
- Run a cost segregation study
- Accelerate the depreciation (”Bonus Depreciation”)
- Convert passive losses into active losses that offset your other active income
By achieving REPS, you have already accomplished the 4th step, which is by far the most challenging.
All you need to do now is run a cost segregation study on your investment property and consult with an experienced CPA who can help you put all the pieces together.
Congratulations! You’re well on your way to creating loads of passive income and generational wealth.
750+ Hours is a Lot of Time
There’s no sugar-coating it. It takes commitment to qualify for REPS.
750 hours spread over a 52 week year is approximately 15 hours per week. If one spouse is not working, but wants to contribute to the household, a 15 hour weekly commitment may be doable.
Still, if you have a full-time job and aren’t married, or if both spouses work full-time, then unfortunately this strategy isn’t for you.
You may be a good candidate for the short-term rental loophole.
It can be expensive to run a cost segregation study. If you use a good firm – one that sends an actual engineer to visit your property – you should expect to pay $3,000-$5,000 per study.
Certainly not cheap, but in context of how much you’ll be saving in taxes, it’s not much.
You will also need a CPA who works with real estate investors. Sorry, TurboTax just won’t cut it.
I can tell you first hand, finding a great CPA is not easy. When you do find someone you like, with the right credentials, do not be cheap.
It’s way too easy to be penny-wise, pound-foolish here. Find the best and pay them fairly.
Depreciation Recapture Tax
When you go to sell your property, if you do not elect for a 1031 exchange, you will need to pay recapture tax of up to 25% on the depreciation you took.
I’m a big believe in the Buy, Borrow, Die strategy, but if you’re looking to sell your property without finding a like-kind real estate asset to exchange into you should expect to pay some recapture tax.
Even still, a dollar in my pocket today (rather than with the IRS) is worth more than a dollar tomorrow.
What forms do I need to fill out on my tax return to convert my passive losses into active losses?
There is a box that you complete on your Schedule E (Form 1040) where you enter the net income (or for our purposes net loss) from “all rental real estate activities in which you materially participated under the passive activity loss rules.”
You do not need to submit your contemporaneous log or any proof of your qualification. The IRS assumes you are being truthful in your election.
I strongly advise you work with an experienced CPA. He or she will know exactly what to do.
What are all seven of the materiality tests?
You can read the seven tests from the IRS directly, if you are so inclined.
You’ll find the language is (intentionally) super confusing, and several of the tests seem a bit duplicative, so I’ve simplified them into 4 buckets below.
- You participate more than 500 hours in the activity
- You participate 100 hours in the activity AND more than anyone else
- You are the only person who participated in the activity. Literally no one else did.
- You participated in the activity for at least 5 of the preceding 10 tax years (does not need to be consecutive years)
For our purposes, “Activity” can be replaced with “Property”.
Remember, you only need to meet one of these criteria to establish material participation.
And again, establishing material participation is separate from qualifying as a real estate professional. Given the 750 hour minimum for REPS, most investors will make the Grouping Election and meet the 500 hour test above (#1).
Can I qualify as a real estate professional if I have a property manager?
It will depend, but in most cases the answer is no.
If you have a property manager, you are likely not involved in the day-to-day activities of the property. This makes it incredibly hard (nearly impossible) for any of your time to count toward material participation.
That’s the position the IRS will take.
However, if you have a large portfolio of rentals, you may be involved in managing the day-to-day operations of the portfolio as a whole… even if you have specific property managers. Your portfolio would likely need to be large and your participation will need to be substantial.
I’m hearing conflicting things when it comes to which hours count toward the 750 hour minimum for REPS. Why?
Ah – classic. I can’t tell you have much conflicting information is out there on which hours do and do not count.
Unfortunately this section of the tax code is a bit grey.
All we can do is try our best to interpret the spirit of the code.
The general litmus test is this: “Is the activity in question something a typical property manager would need to perform”?
If the answer is yes, you should feel comfortable including those hours. Otherwise you shouldn’t include them.
A few other notes related to this topic:
- I would encourage you record more than the 750 hour minimum. If you can get 850-900 hours you have wiggle room if the IRS were to audit your log and discard certain entries.
- Further, it never hurts to log more hours rather than less, even if you’re not 100% sure the hours will count. Just make sure all your hours aren’t in the “maybe” bucket.
- Keep clean records – use a clean time log, use a separate email address for your real estate activities, save receipts and documents where possible, etc. You can never have too much proof if the IRS ever questioned your REPS.
Do I have to qualify for REPS every tax year? Do REPS hours carry over from one year to the next?
Yes, you will need to qualify as a real estate professional each calendar year.
No, your hours cannot carry over from one calendar year to the next.
You will need to meet the REPS criteria every calendar year that you want to take advantage of the tax benefits.
I have a stay-at-home spouse. Can he or she qualify as a REP even though I work full-time?
If one spouse qualifies as a REP, you can file a joint tax return and claim rental losses against the working spouse’s active income.
This is a great strategy applied by many savvy investors.
Just remember, your spouse must qualify for REPS completely on their own. Your hours will not count. And if you were wondering, you absolutely cannot send emails or communicate on behalf of your stay-at-home spouse.
Do rehab and renovation hours count toward the 750 hour minimum to qualify as a real estate professional?
It depends. If you hire a contractor to complete the work, those hours will not count.
However, if you are performing the rehab or renovation yourself, then those hours will absolutely count. In fact, buying a fixer upper and doing the work yourself is a great way to accumulate a ton of hours for REPS.
You can also make the Grouping Election, which will help you establish material participation across all of your properties, even if you spend the vast majority of your time fixing up one property.