Real Estate Professional Status (REPS)

By Jason Watson, CPA
Posted Saturday, August 10, 2024

Why designate yourself as a real estate professional? Aside from being something cool to tell the grand kids, let’s presume that you have a loss on your rental property or in aggregate on your gaggle of rental properties. It is common to have a tax loss on your rental activities although it cash flows, and the primary reason is depreciation. How does this tax loss affect your tax return?

As a reminder, IRC Section 469 defines a passive activity as any activity that involves a trade or business in which an individual taxpayer does not materially participate. Passive losses and material participation are trigger words to make any real estate investor twitch.

Rental income is typically considered passive, meaning that you are not directly earning the income as you would with a W-2 job or as a small business owner. Generally, passive losses may be deducted from passive income. For rental income there is an exception allowing you to deduct passive losses from non-passive income such as wages and business income but there are limits (of course there are!). Passive loss limits for married taxpayers max out at $25,000, and that number decreases as your gross income increases. Yuck!

Specifically, passive activity loss limits reduce $1 for every $2 over $100,000 modified adjusted gross income (MAGI) and by $150,000 (for married couples) the passive loss deduction is $0. Bummer. For a deep dive into passive activity loss limits including how to calculate MAGI, see our passive activity loss limits section.

Not all is lost, however. If your rental losses are capped or disallowed (unallowed is the official word) because of passive loss limits, the portion exceeding the passive loss limit is carried forward on Form 8582, aggregated for each year and may be deducted in the year of disposal (sale). They may also offset future net rental income; you had losses, they were carried forward, you now have rental profits and the suspended losses can be used to offset. We call these PALs (passive activity losses). Sounds fun. Your PAL will come to assist when you have passive income.

There is another angle to all this, and this is the gist of this section- if you are a real estate professional who materially participates in rental activities, as defined by the IRS, and not your bartender, you can deduct 100% of your rental property losses (you are not capped by passive loss limits). This makes sense since your rental income is no longer passive if it is your livelihood or at least a large portion of your livelihood. In other words, the real estate professional status (REPS) is essentially telling the IRS and the world that your rental activities are not something you tend to from time to time but rather are approached with the mindset of a busy business owner.

But wait! There’s more. When the Net Investment Income Tax (NIIT), which was introduced along with the Affordable Care Act, the real estate professional designation became an important tax planning tool all over again. Huh? If your modified adjusted gross income (MAGI) hits a certain amount, the NIIT is charged on all portfolio (interest, dividends, capital gains) and passive activity income (rentals). However, if you are a real estate professional your taxable rental income (profits) is no longer deemed passive and as such is not being taxed by the net investment income tax of 3.8%. $100,000 in rental profits multiplied by 3.8% for 20 years. That could be huge!

Mini Agenda

Here is a mini agenda and references to other sections of our book-

• Qualifying as a Real Estate Professional

• Passive Activity Losses and Their Limitations

• Material Participation

• What Hours Can You Count

We gloss over passive activity losses, material participation and qualifying hours since we covered these topics in depth on the pages above.

Quick Preview of Qualifying as Real Estate Professional

Before we go too far down the REPS road, let’s quickly review the simplified basics of real estate professional status-

• You materially participate and provide personal service hours of 750 or more in real property trades or businesses, and

• Over half of your time spent on all activities where you perform a personal service must be spent on real property trades or businesses (this includes W-2 jobs and small businesses). If you work 2,080 hours as a 9-5er W-2 suit, you will need to work 2,081 hours in real estate. Sure, no one wears suits anymore, but you get it.

If you meet these two, you are what the IRC refers to as a qualifying taxpayer, or what the industry calls a real estate professional. But you are not done! The final step is to demonstrate material participation as a real estate professional in each of your rental activities unless formally elected to group all activities as one (more on the 1.469-9(g) election in a bit).

Could you be deemed a real estate professional by definition but not be able to deduct your rental losses? Yes, technically you could. Like a lame duck, you met the two hurdles above but did not materially participate in your rental property activities, so the whole exercise is worthless. This is more common than you think, and we will show some examples later.

As a reminder, IRC Section 469(c)(7) again for fun-

For purposes of this paragraph, the term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

Passive Activity Losses

Passives activity losses can only be offset by passive activity income. Generally, material participation changes the color of money, and the activity is no longer passive. However, rental activities remain passive even if you materially participate. You must materially participate as a real estate professional. Read that again.

If you cannot leverage real estate professional status or the short-term rental loophole, there is an exception allowing $25,000 of passive activity losses created by rental losses to be deducted against other non-passive income. But you must actively participate.

Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Material Participation

As listed in our mini agenda, we dug deep into the material participation list in a previous section on page xx. In that section we also provide excerpts from the IRS Passive Activity Loss Audit Techniques Guide (ATG) plus our own commentary. Here is the list again according to Temporary Treasury Regulations 1.1469-5T(a)–

(a) In general. Except as provided in paragraphs (e) and (h)(2) of this section, an individual shall be treated, for purposes of section 469 and the regulations thereunder, as materially participating in an activity for the taxable year if and only if—

(1) The individual participates in the activity for more than 500 hours during such year;

(2) The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3) The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4) The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5) The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6) The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7) Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Tests #1, #2 and #3 are the ones used 99% of the time by real estate investors.

What Hours Can You Count?

Let’s try to clear up some confusion on hours. There are two sets of hours. There are the hours that make up the 750 hours test to be called a real estate professional. We’ll call those REPS hours.

The other set of hours is material participation hours. We’ll call those MP hours.

Can MP hours be considered REPS hours? Generally, Yes, they are a subset of REPS.

Can REPS hours be considered MP hours? They might, however, the list of activities that count towards REPS is much larger and includes real estate development, home building, real estate agent activities, among others.

Can the same hour be used for both REPS and MP hours? Yes, provided the hour qualifies for both.

Cool, so, what hours count? We exhaustively discussed this in an earlier section as well on page xx. Investor and research times do not count. Travel time might count depending on your facts (the window is small). Acquisition time might count if you complete the purchase (convert investor hours to acquisition hours). On-call hours do not count; you must “perform” an activity or what the tax code refers to as personal service.

Short-term rentals with average guest stays of 7 days or less cannot contribute to the 750 hours test since they are not deemed rental activities. Wait, what? It’s true! Temporary Treasury Regulations 1.469-1T(e)(3) reads “an activity involving the use of tangible property is not a rental activity for a taxable year if for such taxable year the average period of customer use for such property is seven days or less.”

Sidebar: Don’t confuse tangible property with personal property. Real property is tangible property since you can touch it.

In Bailey v. Commissioner, Tax Court Memo. 2001-296, and again in Bailey v. Commissioner, Tax Court Summary Opinion 2011-22, which are different people with different facts but the same problem- the court used a literal interpretation of “the average period of customer use for such property is seven days or less” and stated that the activity was not a rental activity, and therefore those hours did not count as material participation.

Two spouses cannot combine hours to reach the 750 / REPS hours test. Both spouses may qualify, but if things are tight, it is ideal to pick one person to focus their time on achieving the necessary amount of time.

Again, we beat this up a ton with Tax Court cases and other IRS correspondence in a previous section on page xx. Check it out!

Real Estate Professional Material Participation

If you meet the 750 / REPS hours and more than half of your personal services are in real estate trades or businesses, you are designated a real estate professional. However, and as a reminder, to have your rental activities be considered non-passive so your rental losses are non-passive, you must materially participate in your rentals. Yes, this is nuanced.

For example, many licensed real estate agents can easily prove the REPS hours test for being a real estate professional. However, they might not spend enough time on their own personal rental properties or rental activities, and therefore cannot prove material participation (MP hours).

Regulations 1.469-9(g) Election

You can elect to group all your rental properties into one activity so the material participation test is less onerous. If you had three rentals and were needing to use the 500 hours test for material participation (test #1), you would need to spend 3 x 500 or 1,500 hours total at a minimum.

The Treasury Regulations 1.469-9(g) election is a formal election on the tax return that endures each year unless revoked. What if you forgot to make this election? The IRS has provided relief allowing certain qualifying real estate professionals to make late elections to group all interests in rental real estate. IRS Revenue Procedure 2011-34 applies to a rental property owner who failed to file a timely election to aggregate but who has filed tax returns consistent with having made the election for all the tax years in question.

Is it an election to group or aggregate? A lot of subject matter material out there will use the word “group” but the IRS in their late election relief uses the word “aggregate.” Perhaps we can all agree to group real estate trades or business together for the 750 hours test and aggregate rental properties into a single activity.

Are there downsides to the election? Yes there are. The most impactful problem is the need for a material change before you can revoke the aggregation. If you cannot revoke the election, any combined suspended passive losses allocable to the rental real estate activities cannot be used to minimize capital gains. Is selling one rental out of three material? How about two out of three as Meatloaf sings? Yes, since you no longer have a group, right? How about three out of five? Makes you wonder. There are other issues as well, but the material change requirement for revocation is the most prominent. This becomes problematic when you have unallowed losses being carried over on Form 8582, and you want to use them upon sale of a rental property.

Having said that, most real estate professionals will worry about next time, next time, and will elect to aggregate to ensure material participation is met.

Pitfalls

Here are some pitfalls with real estate professional status-

• Having a management company generally kills off #2 and #3 of the material participation tests, leaving #1 which is the 500 hours threshold. 10 hours a week. Every week. That’s a whole day and then some.

• Having a W-2 job is not an instant killer. However, it becomes an audit risk. You will either need to prove that you spend more hours on real estate activities than your part-time W-2 gig or that you are a 5% or greater owner in a company that qualifies as a real estate trade or business.

• Having multiple rental properties and not aggregating through the Treasury Regulations 1.469-9(g) election (more on that later).

• Poor documentation and crappy corroboration. Or crappy documentation and poor corroboration. You might be considered to have disguised disorganization. The possibilities are endless.

Here is a list of questions and tests the IRS will blast through if your real estate professional status is challenged. We gleaned several items and took some liberties for emphasis and readability from the IRS Passive Activity Loss Audit Techniques Guide–

• Describe the work you perform as a real estate professional. Check occupations by signatures and W-2s.

• Who is the real estate professional, you or your spouse?

• Does the spouse claiming to be the real estate professional work full-time or part-time? How many hours specifically? Are they corroborated with pay stubs?

• Approximately how many hours did you spend working on your rentals in the year under exam? Ask the taxpayer for supporting documentation (appointment books, diaries, calendars, logs, etc.) You may want to give the taxpayer a time log to be completed for each rental – and for each year under exam. Material participation is a year-by-year determination. Rental property activities are generally not time intensive (so says the IRS).

• If the non-working spouse claims to be the real estate professional, ask what other commitments they might have. Is the spouse a student? Is the spouse providing full-time care to young children? Do you see them at soccer practice?

• Who monitors the rental properties? Who collects the rent? Who does the repairs? Who pays the bills and balances the checkbook?

• Do you have a real estate agent or property manager or employee responsible for any of the rentals? Ask for each rental property. Check Schedule E for large commissions or management fees. Also check for large labor expense since a hired contractor might have spent more time than taxpayer (see material participation test #3). If there is paid property management, it is a strong indicator taxpayer did not materially participate.

• Is anyone besides you involved with managing or overseeing any the properties? Does a relative or friend manage/monitor the property for free?

• Does a tenant receive free/reduced rent for managing the rentals – or for caring for the properties?

Indicators that the taxpayer did not materially participate:

• The taxpayer’s residence is hundreds of miles from the rental property. Are there personal reasons for the taxpayer to visit the rental property such as family or friends close by. Did the taxpayer ever live in the rental property and establish relationships nearby?

• The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.

• The taxpayer is elderly or has health issues.

• The majority of the hours claimed are for work that does not materially impact the rental property.

• Rental property operations would continue uninterrupted if the taxpayer did not perform the services claimed.

• 100 hours and more than anyone else: The taxpayer must not only prove they worked more than 100 hours, but more than anyone else. They must be ready to provide evidence of the participation of others. Additionally, there is no provision in IRC Section 469 to divide employee time by each unit.

• Substantially all: It will be very difficult for the taxpayer to meet this test for any condo-type activity that either has a management firm or is located away from the taxpayer’s residence with someone who manages the activity.

• Facts and circumstances: This test cannot be used if anyone besides the taxpayer is paid to manage the activity. An on-site management agency disqualifies the taxpayer from using this test.

• Request a copy of any management or commission agreement. Frequently, there is little left for the taxpayer to do.

• Significant time claimed for reading reports, paying bills or other investor-type hours, which are generally disregarded in the material participation tests.

The notes from the ATG are extremely helpful since it allows the rental property owner seeking real estate professional status to narrow down what the IRS is looking for. Knowing someone else’s argument or perspective ahead of time is essential for audit success.

Strategies

Here are some common strategies for leveraging the real estate professional status (REPS). These are often combined.

• If you are married and one spouse has W-2 income, the other spouse who does not work (or even stays home with the ankle biters) becomes a great candidate for REPS.

• To piggyback, the non-W-2 spouse from above could start an interior designer business that does fix and flips directly, or fix and flip contracting services. At the very least, becoming a licensed real estate agent can generate REPS hours through chasing down listings and representing buyers even if part-time.

• To piggyback the piggyback, this same non-W-2 spouse could be the general contractor on the next rental property rehab for your buy rehab rent refinance repeat pleasure.

• Timing is a big deal too. You buy three rentals and perform cost segregation studies on them for that juicy depreciation deduction. The depreciation deduction is a singular shot and does not repeat. Perhaps your income is also unusually high that year as well. That might be the perfect time to blitz this REPS thing, take your tax deduction and then turn it all over to a property manager the following year. 100% legit.

Tax Court Cases for Real Estate Professional Status (REPS)

Here is a snapshot of some issues the Tax Court has dealt with-

Wallach, Tax Court Summary 2012-94

The taxpayer was a real estate agent who attempted to deduct several travel expenses including Hawaii and Lake Tahoe. He attempted to claim the travel was for investment purposes by researching additional real estate, but his recordkeeping was shoddy and was denied the deduction.

Trzeciak, Tax Court Memo 2012-83

Taxpayer claimed that time traveling to and from rental properties added to the 750-hour and material participation requirements. IRS agent and Appeals officer said No. But it appears from the court records that perhaps the IRS would entertain travel time had the taxpayer asserted a home office deduction for rental property activities. The Tax Court was dealing with a different issue and did not address this on point.

Truskowsky, Tax Court Summary 2003-130

Unless a taxpayer can prove day-to-day managerial involvement, then travel time between a taxpayer’s house and the rental activity is considering commuting and therefore does not qualify towards the hourly requirements for real estate professional and material participation. Commuting according to IRC Section 162 is not deductible. Sorry.

Leyh, Tax Court Summary Opinion 2015-27

Real estate investor had only 632.5 hours on her time log but explained during audit that she had failed to record the time spent traveling among her 12 rental properties. The IRS countered that her log was inclusive of travel time, but based on her testimony at trial, the Tax Court found that she had not included travel time in the time log and allowed her to restate the time log.

Lee, Tax Court Memo 2006-193

In terms of recordkeeping and proving hourly involvement, the Tax Court has acknowledged that “reasonable means” is interpreted broadly. Nevertheless, a post event “ballpark guesstimate” will not suffice. Leave it to the Tax Court to bust out some slang.

Pohoski, Tax Court Memo 1998-17

The court stated the second test of material participation was not satisfied when taxpayers failed “to put forth some indication of the actual time spent by” third-party non-owners such as property management companies.

Manalo, Tax Court Summary 2012-30

To push the taxpayers over the 100-hour hurdle, petitioners introduced at trial three revised logs, including a last-minute log purporting to be a reconstruction of the hours of services Mr. Manalo performed with respect to the rental activities. The estimates in these revised logs, however, were uncorroborated and unreliable. The revised logs were prepared at various instances over a two-year period after the conclusion of IRS agent’s examination and are, according to petitioners, based on emails and archived documents. Those emails and archived documents, however, were never introduced into evidence at trial. The Tax Court stated, “The rule is well established that the failure of a party to introduce evidence within his possession and which, if true, would be favorable to him, gives rise to the presumption that if produced it would be unfavorable.” Yuck!

Kutney, Tax Court Summary 2012-20

Taxpayer used hourly estimates that varied throughout trial. The Tax Court considered this a post event “ballpark guestimate” and denied the real estate professional designation.

Moss, 135 Tax Court 365 (2010)

The rental property owner argued that he should be permitted to include hours spent “on call,” when a tenant could contact him if necessary. The court denied the tax position because the taxpayer was not actually performing services during those hours, the time could not be counted toward the 750-hour requirement.

Escalante, Tax Court Summary Opinion 2015-47

The rental property owner listed hundreds of hours for writing checks and reviewing mortgage statements. The Tax Court considered how long it would take them to write their own checks based on their own experience of daily life.

Lucero, Tax Court Memo 2020-136

Mr. Lucero’s log reported hours for tasks that appear excessive in relation to the task described, such as spending two hours shopping for coffee filters at Bed Bath & Beyond, and included time shopping both for the Sea Ranch property and for personal items, such as one hour shopping at Gualala Supermarket for 2 items for the Sea Ranch property (garbage bags and facial tissue) and more than 20 personal grocery items. We have found the credibility of a taxpayer’s records to be diminished when the number of hours reported appears excessive in relation to the task described.

Iovine, Tax Court Summary 2012-32

Taxpayer was a pilot who worked for American Airlines and worked 812 hours according to timesheets provided. The taxpayer was not able to prove that he spent more than 812 hours on his real estate activities. More importantly he failed to make the election to treat all rental properties as a single activity.

Miller, Tax Court Memo, 2011-219

The taxpayer was a boat pilot. Although he was employed full-time, he worked less than 1,000 hours as a boat pilot. His time logs were kept contemporaneously and appeared to be credible. Further, witnesses testified on the taxpayer’s behalf on the taxpayer’s incredible work ethic and bolstered his credibility. The Tax Court agreed.

Fitch, Tax Court Memo 2012-358

One spouse was a licensed real estate agent while the other spouse worked on the rental properties. The Tax Court found that they satisfied test #2 of the material participation tests since their participation in the rental real estate constituted substantially all of the participation. Mr. Fitch testified extensively as to the activities he performed with respect to his rental properties including advertising, bookkeeping, accounting, dealing with contractors, decorating, resolving fence disputes, making repairs, paying taxes, and procuring insurance. Occasionally hiring a contractor to perform technical tasks does not disqualify the substantial day-to-day management of the rental properties from constituting “substantially all of the participation”.

Chambers, Tax Court Summary 2012-9

Tax Court allows a limited partner in a partnership to count that time towards material participation. Generally limited partners on paper cannot by definition materially participate, however, the actions of the taxpayer actually suggested a general partner and not a limited partner. The taxpayer eventually lost on the 750-hour rule for real estate professional status.

Aren’t we all better criminals after watching Law & Order or American Justice Files? Kidding aside, use these tax court cases as a rubric of what not to do. There are a buttload or boatload depending on your geographical vernacular of other tax court cases.