To be treated as a real estate professional by the IRS, you must meet the following tests:
- Test 1: More than half (50%) of your personal services performed in all trades or businesses during the year are in real property trades or businesses wherein you materially participate.
- Test 2: Perform more than 750 hours of personal services in real property trades or businesses in which you materially participate.
Before applying the tests, eliminate all activities in which you don’t materially participate. If you’re unsure how to determine material participation, see our article on what it means to materially participate.
If you establish material participation in the rental activities, then the income for those rental activities will be nonpassive. As a result, you may use any rental losses without limitation, meaning that you may deduct your rental losses from your ordinary income and ultimately lower your tax liability.
For the purpose of this classification, the real estate activities that you can engage in as a real estate professional include buying, selling, or renting commercial or residential properties or land. It may also include one or more of the following:
- Real property development
- Real property redevelopment
- Reconstruction of real estate
- Acquisition of property
- Property management
- A real estate brokerage trade or business
Test 1: Greater Than 50% of Services in Real Estate
The first burden you must meet for this classification is to spend more than 50% of your time working in real estate trades or businesses wherein you are a material participant. The key to meeting this burden is that your main source of income needs to be derived from real estate activities.
Your total time spent on personal services includes your time as an employee. However, you can only include time spent as an employee toward real estate activities if you owned at least 5% of the company. Also, if you file a joint return, don’t count your spouse’s personal services to see if you meet the other standards.
Test 2: Completing the 750-hour Requirement
The second qualification requires real estate professionals to spend more than 750 hours in a year performing services related to real estate trades or businesses.
Let’s look at examples that take the two tests into consideration.
In 2022, Mr. Y worked as a part-time accountant. He was also a real estate developer, and he owned three rental properties. The following applies to his business activities in 2022:
- Spent 200 hours during the year working as an employee for a local accountant
- Spent 500 hours engaging in real estate development activities for which he materially participated
- Spent 300 hours during the year providing manager services for each of his three rental properties for which he materially participated
Conclusion: Mr. Y is a real estate professional. This is because more than half (80%) of all his personal services performed during the year were in real estate property trades or businesses wherein he materially participated, plus he spent more than 750 hours engaged in these services. Since he is a real estate professional and he materially participated in the three rental properties, income and loss from these properties will be treated as nonpassive.
Mr. X worked full-time as an attorney in a law firm. He also owned a rental property and fixed and flipped homes during the tax year. He engaged in the following activities during the tax year:
- Worked a total of 2,080 hours as a practicing attorney
- Spent 700 hours fixing and flipping homes in which he materially participated
- Spent 50 hours on rental activities wherein he materially participated
Conclusion: Since Mr. X spent more than 50% of his time working as an attorney in a law firm, he cannot classify himself as a real estate professional for the purpose of this rule, even though he has spent 750 hours on real estate activities.
In 2022, Mr. Z is retired but works as a part-time engineer. He also managed five rental properties and invested in real estate during the tax year. The following applies to his business activities in 2022:
- Spent 400 hours during the year working as an engineer
- Spent 350 hours managing his rental property
- Spent 300 hours engaging in real estate investing activities
Conclusion: Mr. Z is not a real estate professional. Although he spent more than 50% of this time in real estate activities, he did not spend more than 750 hours in real estate activities.
Pros & Cons of Being a Real Estate Professional with Regard to Taxes
|You aren’t subject to the passive activity limits for rental activities for which you materially participate. Thus, you can deduct the losses you incur from rental activities from your ordinary income.||If you have profit from a rental activity that you materially participate in, the income is nonpassive. Thus, it can't be used to offset any losses from passive income|
|You can group two or more activities into singular activities to meet the criteria for material participation.||Grouping of activities makes it difficult to deduct prior suspended losses when an activity is disposed.|
Frequently Asked Questions (FAQs)
No, a real estate professional for tax purposes does not require any professional licensing. It is simply a preferential tax designation if you meet the tests discussed in this article.
Yes, you must meet the requirements to be designated as a real estate professional on an annual basis.
In determining whether 750 hours of services have been performed, personal services performed as an employee in a real property trade or business do not count unless you have at least 5% ownership in the business.
If you want to overcome the rule that all rental activities are passive, you must meet the definition of a real estate professional. Being declared a real estate professional can save you tons of money on your taxes if you have rental losses.