Why is it better to be a "Real Estate Professional"?

To say it in one line: Real Estate Professionals can deduct unlimited losses from rental property, other investors can't.

I'll clarify this later, but here's the technicality: material participation in a passive activity (like owning rental property) results in non-passive treatment of the income.

This is what that means:
Most of us know that rental owners (investors) can deduct up to $25k in losses from rental property, but this tax benefit is phased out for households making more than $100k, and completely phased out for AGI's over $150k(Adjusted Gross Income). Their passive losses (rental losses) must be carried forward until they can be offset with future passive (rental) income.

So a doctor, for example, who makes $150k a year cannot deduct any rental losses from income... unless the spouse is a real estate professional...

That's because the only way to deduct rental losses (passive losses) from non-passive income (wage or other income) is by materially participating in the activity, resulting in non-passive treatment of the income. People that materially participate in real estate are considered "Real Estate Professionals" and their major benefit is that their losses can be unlimited.

Real Estate Investors can qualify as "real estate professionals" if they spend at least 750 hours per year on their investment activities. A real estate sales license is not required and either spouse can qualify. Real estate brokers, realty sales agents, property managers, builders, contractors and leasing agents are all considered real estate professionals if they spent 750 hours on real estate business.

If you or your spouse’s answer to any of these tests for determining material participation is yes, it is considered material participation, and you can treat your rental income as non-passive and claim unlimited losses:

1. Do you work more than 500 hours a year in the business?
2. Do you do most of the work? If your participation is the only activity in the business, you materially participate…(ie sole proprietor with no employees)
3. Do you work more than l00 hours, and no one works more? If you put in l75 hours a year and an employee works 190 hours a year, you do not meet the material participation test.
4. Do you have several passive activities in which you participate between 100-500 hours each, and the total time is more than 500 hours? The following activities should not be included in the above test: rental activities, activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.
5. Did you materially participate in the activity for any 5 out of l0 preceding years (ie taxpayer who retired and children now run business, but taxpayer stills owns part of partnership)
6. Did you materially participate in a personal service activity for any 3 prior years? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
7. Do the facts and circumstances indicate that you are a material participant? This test does not apply if:
a. you worked less than 100 hours a year
b. any person, other than you, received compensation for managing the activity
c. any person spent more hours than you managing the activity

You should however check with a tax advisor. In California, several real estate agents have been audited, and the IRS is claiming that they do not qualify as real estate professionals. You should try to find out more to be on the safe side...

So, to sum it up, regular investors have "tax limits", and real estate professionals don't - Real estate professionals can claim unlimited investment property losses against their AGI regardless of how much they or their spouse earns. People at high income brackets cannot due to loss limitations, so many of them resort to becoming real estate professionals.

I hope this explanation was easy to understand and hope that it can be helpful for you or your clients. To learn more about deductible losses and material participation, take a look at these tips.