Real estate professional status and how to qualify
By default without the real estate professional status rental real estate income is categorized as passive. That means losses are limited to only offset passive income and if there is not any then they are suspended until there is passive income to offset or the entire activity is disposed of. There is a special rule to free up the suspended passive losses each year. If there was active participation, a much lower standard than material participation, then a maximum $25000 loss can offset non passive income. The AGI over $100,000 cuts the maximum allowable loss in half. AGI of $150,000 or more completely wipes out the deductible loss to zero, suspending the loss until it can be taken in another year.
Real estate professional status does not recategorize the income. The income remains passive, no self employment tax, but the losses are fully deductible against non passive income. To be eligible all three tests must be passed which is really difficult with a non related full time job. Maintaining contemporaneous detailed logs of the hours and involvement are essential to substantiate and determine if the tests are met. The log should include at a minimum; Dates, hours, description of services, and location. Keep in mind the IRS does not accept ballpark numbers, which is why this log will become essential again.
Real estate professions involve: Developing/redeveloping real estate, Constructing/reconstructing real estate, acquiring real property, converting real property, renting/leasing real property, operating or managing real property trades and businesses, and brokers of real property. The three tests are in bold below and must be met each year to qualify that year. Some years it may be met, others not so much.
More than half of your personal services in all trades or business are in real property trades or business. A Full time job is 2080 hours a year, making 2081 hours in real property trades or businesses the amount that is needed. It is rare to work 80 hours a week all year, most would not meet it if they have a full time job that is not in real property trades or businesses. Well what about licensed real estate agents and mortgage officers at banks working as an employee with no ownership interest? They would have a tough time passing this test because only wages paid to more than 5% owners would qualify as countable hours for this test.
Must perform at least 750 hours annually in real estate professions. The same hours worked in real property trades or businesses to meet the 1st test can be reused to pass this test. Spouses cannot combine hours to meet this or the previous test, they pass the tests separately. If only one spouse can pass all three tests that is fine, its only combining hours to meet the first two tests is not allowed.
Real estate professionals must materially participate in each rental activity. The material participation test the IRS focuses on is just the 500 hours, but there are more tests that can be used to meet this threshold on Pub 925 page 7. Spouses can combine hours for this test. An election on the tax return can be made grouping all the rentals together to make meeting the material participation easier. All three tests must be passed each year to qualify for real estate professional status.
