Everything You Need to Know About Real Estate Professional Status (REPS) to Help You Lower Your Tax Burden
As a general rule, real estate investments are a major factor in why the wealthy obtain and maintain their wealth.
Why is this?
You’re no doubt aware of the extraordinary benefits of real estate ownership that can help create wealth and the numerous tax advantages afforded to real estate investors through the tax code rules. Such rules allow for rental losses, phantom expenses, and depreciation which can help to build one’s wealth in ways that most wall street investments do not allow.
The wealthy earn well, but that also means that their tax liabilities are high as well. You can try to maximize your retirement contributions and be diligent about your write-offs, but high-income earners manage to be responsible for high tax bills unless they learn ways they can mitigate their tax burden.
It wasn’t that long ago that high-income earners were generally self-employed and they were able to utilize the tax code in their favor to keep more of what they earned. But as many professionals (such as doctors, lawyers, engineers, etc.,) moved away from having their own businesses and are now more likely to be employed by large companies their ordinary income is being hit hard by taxes.
What’s The Solution?
What’s a solution for high-income earners to be able to keep more of what they earn? Real Estate Professional Status (REPS) or Rep Status.
In this article, we’ll go over what REPS designation is, how qualifying for REPS can help you decrease your overall tax burden, and why it may be beneficial to your family’s bottom line to have you or your spouse manage your real estate holdings full time to take advantage of this benefit within the internal revenue code.
If you or your spouse earn a high income, and you’re seeking ways to reduce your taxes, then this may be beneficial to you. You can learn how this relatively simple strategy can help you dramatically reduce your tax bill.
How Does REPS Help High-Income Earning Families?
Scenario One
Let’s say you’re married and you file jointly and let’s say you make over $150,000 per year jointly. In this particular scenario, you wouldn’t be able to utilize any passive real estate losses to offset your taxable income because there are no “special allowances” according to the IRS. The passive loss rules work in this way: passive losses can be carried forward on your tax return until such time that you may have passive gains from real estate investments. Passive losses cannot offset the active income that you would receive from W2 employment.
(bummer right?)
Scenario Two
Now let’s flip this scenario and say you or your spouse meets the qualifications to have Real Estate Professional Status. How does that change things financially for you? Let’s take a look.
Let’s say we have Sarah and Matt who are a married couple. Matt is a physician who makes $250,000 a year while Sarah is raising the couple’s two children and managing the family’s real estate investment portfolio, which has become a full-time job.
The couple’s real estate portfolio of rental properties that Sarah is managing has a paper loss of $150,000 with all of the allowable deductions and expenses. Let’s say Sarah is qualified to have REP status. In that scenario, the couple can deduct the $150,000 (passive) loss from Matt’s $250,000 (active) income, which leaves only $100,000 in taxable income (and puts them in a lower tax bracket) as opposed to the full $250,000 of Matt’s income that would be taxable without one of the spouse’s having the REP status designation to offset the tax consequence.
Without Sarah having the REP status designation, the $150,000 in passive losses will need to be carried forward until there are any passive gains in which to apply to the losses. In the meantime, the couple would be taxed on Matt’s total $250,000 income. Without the REPS, the couple could potentially have almost double the taxes.
REPS can help high-income earners reduce their tax liability by allowing their real estate deductions to offset earned income.
What Is Real Estate Professional Status?
Here’s what you should know about how to qualify for a REPS designation. You don’t need to be a real estate agent or have a real estate license or have a special license of any kind but there are important things you need to do to be compliant with being able to qualify as a REPS.
Here are the rules:
- More than half the personal services you performed in all trades or businesses during the tax year were performed in real property trade or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
This is explained more in-depth in IRS Publication 925, but in a nutshell, real estate must be one spouse’s primary job. There’s not too much time beyond 750 hours within a year to be able to do another job unless it’s very part-time, so the rules are clear and you may even want to keep a time log and calendar of all of your real estate-related activities if it were ever to be challenged. It certainly can’t hurt to keep documentation.
How To Achieve REPS
You may be asking: “Why have I never heard about this before?”
Now, let’s get you on a plan to get this set up for your own family, right?
First, you’ll want to determine which spouse will gain the REPS. Just know, that if both of you have full-time jobs, you will not be able to qualify likely, for REPS – it really has to be a full-time job in and of itself.
Beyond each spouse’s work roles, you will want to weigh such factors as each spouse’s passion for their career or each spouse’s passion for real estate (or not), each spouse’s abilities and strengths, and who would be the best fit to attain REPS.
Whichever spouse becomes a real estate professional, they will need to be very serious about conducting the activities as a business and documenting EVERYTHING to make sure they can justify their time commitment.
Be sure to talk this over with your CPA so that they can help you coordinate the timing in qualifying for REPS, the real estate purchases you may want to consider, what you can and should be documenting for status purposes, and the tax filings. From there, determine how much you want to invest, start real estate shopping and get ready to invest. Just be sure to track all of your real estate-related activities consistently.
Other Helpful Tips
Other helpful tips that can help solidify your REPS is to have a designated business account for your real estate business, and a separate business email address for real estate-related activities. Always be thinking of ways that differentiate your real estate investment management activities from any personal activities you do on a daily basis and remember to document the time you spend on the business to justify the 750 hours required a year.
Making REPS Work For Your Family
REPS status will look different for every family no doubt, so let’s take a look at a couple of different scenarios.
Scenario 1: Two working spouses, one spouse who works full time and loves their career and is the high-income earner for the family primarily. The other spouse works part-time while materially participating in managing the couple’s real estate investment portfolio of real estate rentals.
Scenario 2: One full-time working spouse and one spouse who is stay at home and manages the real estate investment portfolio full-time for the family.
In each of these scenarios, the spouse who is managing the real estate activities will need to commit their material participation in the day-to-day operations and to be able to demonstrate that they have indeed worked in that real estate business for no less than the 750-hour requirement during the taxable year.
Keep in mind in order to work 750 hours during the course of the year in real estate-related activities means you will generally need a good-sized portfolio or you are working very diligently to acquire a good-sized portfolio. Treat your real estate investments as a business and you will likely have no problem producing the documentation needed to prove you materially participated in the required 750 hours or more each year to be sure you are compliant under the watchful eyes of the IRS.
Get Your CPA’s Guidance
Again, you will want to speak with your CPA about how to go about getting the designation but they will likely want to include this language in your tax returns:
Under IRC Regulation 1.469-9(g)(3), the taxpayer hereby states that they are a qualifying real estate professional under Code Sec. 469(c)(7), and elect under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.
The particular phrase: “taxpayer hereby states that they are a qualifying real estate professional” is critical to get the status.
If you or your spouse can meet the IRS guidelines as it pertains to REPS, then this could create some real tax advantages for you and your family.
Is Real Estate Professional Status For You Or Your Spouse?
If you’re married and file a joint return and at least one spouse has an income of $150,000 or more you may have been feeling the pinch of having a high tax consequence. In fact, taxes might have even prompted you to start reading more about real estate investing in the first place because you have always heard how real estate is the best way for most people to offset their tax liability.
Well, now you have learned how you can apply your real estate investment paper losses against active income – W2 income – by attaining Real Estate Professional Status. Otherwise, without the status, you could be stuck carrying those passive losses for years and years to come.
Remember, I’m not a CPA, nor am I a Financial Advisor so I’m going to advise you to always talk with a tax and or financial advisor before making any financial decisions. I do hope though that this has spurred your interest in learning more about all of the amazing tax benefits that real estate investing has to offer you.
Until next time, Earn Passively & Live Abundantly!
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