As a real estate investor, you have to contend with mortgage payments, repair and maintenance, insurance, and other myriad fees. On top of all of those fees, you still have to pay tons of taxes—capital gains, net income investment, and income.
Sometimes, it’s hard to carve out profitability, and you want to have all the weapons in your arsenal to combat your tax burden.
Sound like you? You’re in the right place.
This article doesn’t list every tax break you have available to you as a real estate investor.
What is in this article is a tactic that works. Establishing a real estate professional designation for yourself reduces the amount of tax you owe, improves your cash flow, and acts as a step toward securing your financial freedom.
The short answer is that it might save you money. It’s essential to determine whether your involvement in real estate activities makes you a real estate professional for tax purposes.
First, the real estate professional designation establishes if you can deduct losses from your real estate activities against ordinary income. Second, it determines if your income from real estate investing is subject to the net investment income tax.
IRS Sec. 469(c)(2) states that rental activities are considered passive activities regardless of your level of participation.
That is important to you as a real estate investor because:
That means your passive losses from those activities are only deductible against your passive income activity income.
However, if you qualify as a real estate professional, the passive activity loss rule doesn’t apply to you.
That enables you to deduct losses from rental real estate against nonpassive income. Examples of nonpassive income include:
You have the potential to reduce your taxable income close to zero and increase your cash flow.
A net investment income tax of 3.8% applies to income over the threshold amount. The threshold amount is:
However, there is an exemption for gross rental income from being included in investment income for real estate professionals.
You, as a taxpayer, qualify as a real estate professional for any year as long as you pass three tests with your real estate business:
Test 1: Material participation means that you participate through the year on a regular, continuous, and substantial basis. There are seven ways you can “materially participate,” so finding a way to qualify is surprisingly easy.
Test 2: You must spend at least 750 hours per year in real property trades or businesses in which you materially participate. Personal services performed as an employee do not count unless you (as the taxpayer) are at least a 5% owner of the trade or business.
Test 3: You must spend more than 50% of your working time on real estate activities in which you materially participate.
For the real estate professional designation, an actual property trade or business includes, but is not limited to:
If you meet the requirements of the three tests and have documented proof, when you file taxes, you will file an IRS Section 469(c)(7)(A) Election to Aggregate Rental Real Estate Activities. The election is a written statement sent with your return for the tax year of the election.
The IRS recognizes three categories of real estate investors. The third category, “real estate professional,” enables you to deduct 100% of your real estate losses against ordinary income. You can even deduct your real estate losses against your spouse’s income!
You might have one rental property or several properties. As a property owner, when you take the real estate professional election, you can create thousands of dollars in tax deductions. Those tax deductions may result in no tax liability at the end of the year.
As you will quickly learn, real estate has incredible potential with the sheer number of tax breaks to create cash flow.
One of the top strategies that savvy investors use is qualifying as a real estate professional.
As a real estate professional, you can:
To learn more about this powerful tax savings strategy and others that you can use to keep more of your earnings, book a tax consultation by taking our tax quiz. The information you provide will enable us to have a productive discussion the first time that we speak.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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