Real Estate Pro? Or No?
One of the biggest challenges real estate investors face is keeping the profits that they earn from their investments. Just like any other business, the IRS is going to want to take as big a chunk of your profits as possible, and knowing how to use the system to your advantage will help you keep as much of your hard-earned investing cash as possible.
One of the best ways to limit the financial impact of taxes when it comes to real estate investing is to be able to claim “Real Estate Professional” status on your tax returns. If you can do this (and that’s a big IF), you have some hefty tax advantages you can leverage to keep more of your investment profit.
First, let me take a minute to explain in more detail the advantages of claiming “Real Estate Professional” status on your tax returns:
If you invest in real estate part time (not a professional), you may be able to deduct a portion of your RE losses on your tax return. If your adjusted gross income (AGI) is less than $100,000, you can deduct up to $25,000 per year in RE losses against that income. This benefit phases out (incrementally drops from $25,000 to $0) if your AGI is between $100,000 and $150,000. And if your AGI is over $150,000, you don’t get to take any RE losses in that year. That said, any losses can be “carried over” and used in subsequent years, based on the same AGI criteria.
The benefit to declaring “Real Estate Professional” status is that all real estate losses can be claimed against income in that year, without limitation based on AGI.
So, if a part time investor (who makes less than $100,000 per year) racks up $75,000 in real estate losses in 2008, he can deduct $25,000 of those losses in each of 2008, 2009, and 2010. If he continues to rack up losses in 2009, 2010, etc, those losses will also have to be carried forward. In contrast, a Real Estate Professional in the same situation can deduct the full $75,000 against AGI in 2008, and can do so with the additional losses in subsequent years.
The big question for most investors is not “Do I want to declare Real Estate Professional status?” but “Can I legally declare Real Estate Professional status?”
The IRS rules for claiming Real Estate Professional Status are very clear, and require that two key criteria be met in the given tax year:
- More than half of the professional hours worked throughout the year must have been devoted to material participation in real estate activities;
- More than 750 hours of material participation in real estate activities in the tax year being considered.
If you think you can satisfy both of those criteria in a given year, I highly recommend working with your CPA or accounting professional to ensure that you properly document your time and efforts to allow you to claim Real Estate Professional status, and in return, keep more of your hard-earned profits.
i wish there was a smiple way to figer out how much profit i can make and how much i have to give way to the goverment
So when you say:
“you can deduct up to $25,000 per year in RE losses against that income”
What losses are you referring to? Is this like depreciation, where it’s not an actual occurrence (in other words, your property hasn’t really depreciated at all), but a deduction we’re allowed to claim for being Real Estate Professionals?
Because frankly if I’m losing $25K a year, I might want to re-think my profession, lol!
Hey Sharon,
Depreciation is the big one. Though in some years, you may have some major expenses (new roof, new HVAC system, etc) that actually causes you to lose money on a property in a given year. That said, you should be making up for that loss by earning greater income in other years…just make sure you save some of that income as reserves for when the big-ticket expenses come around…
Since the goal of a flipper is to not enter into a deal where you can’t make money (I.e. “you make your money when you buy the house”), under what circumstances would you expect to lose $25,000?
Hey Todd,
You shouldn’t ever expect to lose $25,000… 🙂
The value of the passive loss rule is that when you own rental properties, you can claim depreciation for your rentals at the end of every year. This shows up as a loss on paper, even though you’re not really losing money. Depreciation is great because it decreases your tax burden, and sometimes, if you have enough properties, your depreciation can actually take your profit negative (at least on paper).
Another question: I may be understanding this wrong, but I had a CPA (not a real estate one) mention that she thought that income and expenses works differently for real estate than it does for other businesses. For instance: If I had $100,000 profit in a year at a typical business, but decided to buy a $50,000 machine, I could count the cost of the machine all at once or I could depreciate it over time. But, if chose to take it all at once, then my income would show $50,000.
From what I understand about real estate, this isn’t the same. For instance: If I buy a house for $50,000 spend $25,000 in rahab costs and then sell for $115,000, then do the same thing 4 more times in a year (making $40,000 five times for a total of $200,000 profit) and then buy a $250,000 home (my original money plus profit) right before the year ends, then I can’t show that I made no money since all of my profit was put into another house “expense”. If I understand rightly, even though all my cash (and profit) have all been put into that other home and I am sitting at the end of the year with $0 in my pocket (theoretically), then I would still have to show that I made $200,000 even if I didn’t pay any of it to myself, but only used it to put back into more properties.
Now, I know that was an earful and I hope I wasn’t too confusing. But, is that correct? Is that the way it works? Or is there some way to count the cash you are putting back into other properties against some of the profit you have made to lower your tax burden?
Hey Todd,
I agree with the CPA that the situation you describe is correct — you would have a $250K house, $0 in your pocket and would owe taxes on $200K. The difference between this example and buying a machine for your business is that the machine for your business is an expense (something you use in your business), whereas the houses are inventory (the things your business uses to make money by buying and selling).
Now, that said, I disagree that this is because real estate is different than other businesses. No matter what business you’re in, your expenses are deducted (and in many cases depreciated) while your inventory is not. For example, you talk about buying a machine for your business. If your business was to buy and sell those machines, then they wouldn’t be expenses, they’d be inventory, and they’d be treated exactly like houses are treated in your real estate business.
Does that make sense?
Yes, I understand what you’re saying. I guess the eternal optimist and penny pincher in me is determined to find some way to lessen the tax burden without having a lot of depreciating rentals up front. I have been studying a lot, but haven’t seem to find any way around it. (Ho hum!)
Todd –
If you’re buying and selling houses, you’re running a business, not investing. And income from businesses will be submit to ordinary income taxes. There aren’t too many ways around that.
That said, if you set up an s-corp (or LLC taxed as an s-corp), you can pay yourself some of your profits as distributions (instead of salary) and can avoid self-employment taxes for that portion of the income.
Bingo! That is what I was trying to find out from you. When I told you about what the CPA said, I guess I got the impression that a real estate business is different in the sense of expenses, distributions, etc. I actually have a business now (printing and promotions) and run it the way you mentioned above (S-corp). I pay myself a salary and then distribute a decent portion of the profits to me and my wife. I didn’t realize that I could do the same with real estate. Thanks a million!
Hey–
First of all I purchased your book(s) and they are great. Long time fan of the website, too. Very inspiring. Now–
I’ve flipped 5 or 6 houses in the past (over the last 12 years) but I’m ready to get serious about it as a business. I am a licensed Realtor in the state of Florida and I want to be able to become my own best client— purchase and then list and then sell properties I rehabbed. In the beginning I want to focus strickly on fix and flip however I’ll always have retail clients as a Realtor who purchase properties other than my own. The bigger picture and longer term goal is to have a portfolio of rental properties which I’ve purchased throught the profits of fix and flips.
I went to a CPA yesterday and he seemed to be suggesting that I start with 2 separate entities— an S-Corp for my business as a Realtor and a S-Corp as a professional dealer. When the time comes and I begin to amass the rental properties, he suggested an LLC for those.
My question to you is—and I realize it’s only your opinion— does this sound like sound advice? Your and your wife are licensed, correct? I understand the reasoning behind separating the Realtor biz from the Flip biz but both S-Corps? How do you guys have this structured in your business? And also— can you tell me what the benefit of having a LLC taxed as a S-Corp Vs. a straight out S-Corp.
Phew! Thanks ahead of time!
Hey Robb,
I’m no CPA or accountant, but this sounds like sound advice to me, and this is exactly how we have our entities set up (LLCs taxed as S-Corps for both agent income and flip income). We actually have one main business entity that we use for both agent and investment income (not two), but assuming the cost of owning two entities isn’t significantly higher than the cost of owning one, I don’t see any downside to splitting the businesses (and it’s probably cleaner for your accountant).
In terms of S-Corp vs LLC taxed as an S-Corp, from an IRS perspective, they are identical — the IRS doesn’t know or care which way you’re doing it. But, from a legal standpoint, maintaining an LLC is a lot less cumbersome than maintaining a corporation, just in terms of paperwork, etc. So, most business-people I know highly prefer an LLC taxed as an S-Corp over an S-Corp. There are some legal situations where the actual corporation is better, but from a tax standpoint, they are equivalent.
You Rock. Thanks!
I decided to write the CPA after you responded to my question and ask him if he had a preference between the LLC taxed as an S-Corp vs a S-Corp. It’s not a subject that came up when I interviewed him. Here is his response. It might help people like me who read your blog looking for answers and then again, maybe not. The (relative) simplicity of the LLC is a powerful draw!
“Remember though, although you are taxed as an S Corp., legally you are still an LLC. Certain tax benefits available to S Corp are not available in that situation. For example, if you end up with a large loss in your business upon disposition, you can claim Sec 1244 Stock Loss, 50,000 for single, 100,000 for married. You cannot do this with LLC taxed as S Corp.”
Hi Robb,
Section 1244 of the tax code is the ONLY situation I know of where LLCs are treated differently from corporations in terms of tax implication. For this reason, it’s generally recommended that certain types of business (retail, high risk, etc) aren’t structured as LLCs; but according to my CPA, those situations are rare, and 99% of the time, LLCs are just as good as corporations from a tax standpoint.
That said, I’m not a CPA. But, my CPA is pretty clear on this topic…
I found this post and the follow-up comments informative and helpful. My partner and I have several investment properties and have just become more serious in our endeavor; getting my real estate license for starters. I think I’ll be able to claim RE Pro on this year’s taxes, but based on this post, I’ll be checking in with our CPA soon on how to document my work. I hadn’t realized the difference in depreciation that can be deducted- thank you for the specifics!
The legal entity is another area I need to look into more- we haven’t gotten a business license or formed an LLC/partnership/corp. I still need to seek legal advice, but the LLC seems to be the most popular route.
Thanks to J Scott and the comment contributors!
Scott:
Great material.
I am a licensed RE broker and work full time in the business. My wife and I file jointly. She owns a residential property in her name alone. She does not work in the real estate business. To your knowledge, should we be claiming “Professional RE status” on our returns? I have used Turbo tax over the years and it is not clear. Thanks
Hey Steve,
Unfortunately, I don’t know the answer to your question. Sorry!
Hi Scott,
Great material here! I am just starting and am currently devouring your blog’s content (including comments) as well as your books.
After reading the comments, I kinda got the part of the depreciation and how that works to reduce your tax liability at the end of the year.
My question here is whether doing a 1031 exchange in order to re-invest the profits from a flip work as another way to minimize (or delay in this case) paying taxes on the flip profits?
Say profits from the first flip are 20k. If I did a 1031 exchange and re-invested the 20k (plus whatever I had put down on the first flip) on another (possibly larger property) purchase before having to pay any taxes, wouldn’t this allow the possibility of me compounding the profits and then pay only taxes on the profits of the second flip rather than paying taxes on each one individually?
I appreciate your time and effort in putting this together and your time in responding to these questions!
Hey Patrick,
Unfortunately, 1031 exchanges aren’t allowed for flip properties. You can only do a 1031 exchange on an “investment” property, which typically means a buy-and-hold. If it were possible to do a 1031 on a flip, I would most certainly recommend it…