How to Gain a Tax Advantage with Real Estate Professional Status (REPS)

April 1, 2024

If you invest in real estate, then you may wonder whether you qualify for real estate professional status (REPS) and the tax advantages it affords. In the following guide, learn about the three tax categories of real estate investors, how REPS is defined by and demonstrated to the IRS, and what tax advantage you gain with REPS. Let’s talk real estate!

3 tax categories of real estate investors

The IRS distinguishes real estate investors with three categories for tax purposes. Here’s a quick look:

  • Passive Investor – This is the default real estate investor status. If you are considered a passive investor by the IRS, then you can only deduct passive real estate losses against passive income on your tax return.
  • Active Investor – With active investor status, you may deduct an additional $25,000 of real estate losses against your income on your tax return. However, this tax deduction phases out when your Adjusted Gross Income (AGI) exceeds $100,000 as a single individual or $150,000 as a married couple filing jointly. It’s pretty easy to attain active investor status; you don’t need to make a special election on your tax return, but you need to be involved in the decision-making process for your real estate investments.
  • Real Estate Professional – Since you can’t take losses on real estate investments if your income exceeds $150,000, the real estate professional status can help you gain a tax advantage. If you own a number of rental properties or have an extensive real estate investment portfolio, then you may benefit from REPS. Making this special election on your tax return could save you thousands of dollars in taxes, but you will need to prove your eligibility to the IRS.

How is real estate professional status defined?

According to the IRS, real estate professional status is given to individuals who fulfill specific conditions which prove they spend the majority of their work time on their real estate activities.

How to demonstrate REPS to the IRS

In order to obtain REPS, you must satisfy the following three conditions:

  1. The 750-Hour Rule
  2. Greater Than Half of Professional Time Rule
  3. Material Participation

Let’s take a look at each of these conditions in greater detail.

1. The 750-hour rule

The IRS requires that you spend at least 750 hours on “real property trades or businesses” throughout the year, and it outlines exactly what counts toward those 750 hours:

  • Development
  • Redevelopment
  • Construction
  • Reconstruction
  • Acquisition
  • Conversion
  • Rental
  • Operation
  • Management
  • Leasing
  • Brokerage

All of the activities outlined above involve active real estate work.

The following active investment work does not count toward the 750 hours:

  • Education
  • Commuting
  • Researching properties
  • Reviewing financial statements
  • Managing the finances of an activity in a non-managerial capacity
  • Preparing financial or operational summaries
  • Work done “primarily for the purpose of avoiding disallowance of losses”

The point of the 750-Hour Rule is to ensure that you are spending the bulk of your available work time on your real estate activities.

If you get audited by the IRS, you will need to demonstrate proof of the 750-Hour requirement with proper documentation, such as a time sheet with detailed records of dates, times, and activities done.

Note: If you are an employee, then your employee hours don’t count toward the 750-hour requirement unless you are also an owner of at least 5% in the business or property.

2. Greater than half of professional time rule

This rule is basically just what it sounds like: the IRS wants you to demonstrate that you spend more than half of your professional work hours on real estate activities. As with the 750-Hour Rule, you will need to provide proof of fulfillment of this requirement with the proper documentation. The purpose of these rules is to ensure that real estate activities are more than just a side gig; they should be your main profession if you are going to qualify for the tax deductions they afford.

3. Material participation

The third rule for qualifying for REPS indicates that you must be materially participating in your real estate activities. That means you yourself must be actively involved in the activities required to manage your real properties—not just your property manager. Your spouse cannot contribute work time to the 750-hour requirement, but their time can count toward the material participation requirement.

According to the IRS, in order to demonstrate that you materially participate in your real estate activities on a “regular, continuous, and substantial basis,” you must satisfy one of the seven following tests:

  1. You participate in the activity for more than 500 hours during the tax year.
  2. Your participation in the activity for the tax 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. You participate in the activity for more than 100 hours during the tax year, and your participation in the activity for the tax 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 for the tax year, and your aggregate participation in all significant participation activities during such year exceeds 500 hours.
  5. You materially participated in the activity for any five tax years (whether or not consecutive) during the ten tax years that immediately precede the tax year.
  6. The activity is a personal service activity (i.e., it involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting or in any other trade or business in which capital is not a material income-producing factor), and you materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year.
  7. Based on all of the facts and circumstances, you participate in the activity on a regular, continuous, and substantial basis during such year.

Fulfilling these three conditions to the satisfaction of the IRS, with the proper documentation to show for it, qualifies you for real estate professional status.

Tax benefits of REPs

Once you gain REPS, you can take advantage of the significant tax savings it affords. As a real estate professional, you may take otherwise passive losses from real estate investments and deduct them from your active income. This tax strategy could potentially save you thousands of dollars.

Note that this tax advantage only applies to any real estate losses you have.

Also note that if you do not qualify for real estate professional status, the losses carry forward into future years to offset future rental income, including the capital gains when you sell the business.

If you have multiple real estate properties, then you may want to consider whether you are in a position to attain REPS and benefit from the tax savings it offers. The rules and requirements for REPS can be complex, but the experts at Honest Buck can help. Reach out to speak with one of our accounting professionals about a tax strategy that works for you.

Share this article