Geoffrey Kayton, CPA
10.25.21 | TAX Chat
In this post, I will cover the real estate professional rules for tax purposes. What does it mean to be a real estate professional? How does a taxpayer become one? And what does it mean for an annual tax bill? Before getting into the particulars of being a real estate professional, let’s go through a punch list of tax concepts you need to understand when owning real estate. If you need help understanding any of the terminology below, please contact your Berdon advisor.
Understanding Real Estate Terminology
Real estate ownership is generally treated as a passive activity (and sometimes portfolio), which is usually not favorable. Passive income from real estate ownership is subject to the net investment income tax (3.8%), but not self-employment tax. The sale of rental real estate held for at least one year is afforded preferential capital gain rates – a gain of up to the amount of depreciation taken on the property is taxed at either ordinary income or a special income tax rate of 25% (unrecaptured 1250 gain) depending on the nature of the property depreciated. Any gain in excess of depreciation is taxed at 20% (1231 gain or capital gain).
Another important concept to understand is the passive activity limitation. A passive activity is one in which a taxpayer is not regularly, continuously, and substantially involved (i.e., material participation). Generally, this limitation forces matching of passive losses with passive income and, in many cases, limits passive losses in excess of passive income. Losses from passive activities are generally not allowed to offset other types of income (e.g., interest, dividends, or business income). Any amount disallowed is suspended and carried to future tax years.
Who is a Real Estate Professional?
Now that we covered the basics, let’s discuss the specifics of being a real estate professional for tax purposes. The two main benefits are: the activity is not passive, so losses are not subject to the passive activity loss limitation, and the income is not subject to the net investment income tax. However, you should note that other provisions can limit the losses from these activities.
Becoming a real estate professional for tax purposes is generally not elective – meaning once the tests are met, the treatment is forced. I say generally because there are aggregation elections, which can affect the tests. To qualify as a real estate professional, a taxpayer must spend more than 750 hours materially participating in real estate activities, and that time must encompass a majority of the taxpayer’s professional career during the year. This qualification test is applied annually. Another important consideration – if a person owns real estate and works for a management company, that person must own more than 5% of the management company for the hours to qualify.
Meeting the test for qualifying as a real estate professional is complex, and therefore, you need to adequately plan and document your real estate activities. Being a real estate professional is beneficial in many cases, but there are cases where the nonpassive treatment of the income can increase tax. The taxation of passive and nonpassive real estate is also complex, so having experienced advisors is a must; it can drastically change the timing and amount of tax liability. If you are looking for a real estate advisor, Berdon’s real estate practice is second to none.
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Geoffrey Kayton is a Senior Tax Manager with more than 10 years of professional experience. He advises a diverse array of clients across the real estate sector on a variety of tax matters.