There are many tax breaks that come with real estate investing. There may be tax deductions available when you make the purchase, when you own and operate it as a rental and when you wish to sell. One of the major tax breaks for the ownership and operation phase is to qualify as a real estate professional.
Why a real estate professional? In general, there are very tight limitations for which taxpayers can deduct a loss from the current year’s rental operations. And losses are common, especially with properties that are leveraged (a mortgage) and when depreciation is properly calculated. If you do not qualify as a real estate professional, the maximum loss permissible (in total, not per property) is $25,000 per year. And this maximum only applies if you can keep your income under $100,000 for the year. For every $2 your income goes over this amount, you lose the ability to deduct $1 of losses. Thus, when your income reaches $150,000 per year, your rental property losses are eliminated. Unless you qualify as a real estate professional.
How do you Qualify? A recent tax court case, Sezonov v. Commissioner, T.C. Memo 2022-40, reminded us of the rules:
Number One: More than 50% of the time you spend working in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate; AND
Number Two: You must spend more than 750 hours on your real property trades or businesses.
End Result: If you satisfy both tests, your real estate losses aren’t considered to be passive, and all losses can be claimed against other income.
The Problem: If you are audited, you are responsible for proving that you are entitled to be classified as a real estate professional. Thus, it is up to you to prove that the number of hours in your real estate enterprise was more than 750 and that you worked less than this number in all other non-real estate trades or businesses.
The result in Sezonov: No real estate professional status because the taxpayers failed to keep adequate time records and thus could not prove that they satisfied either of the tests (and they needed to satisfy both). Don’t let this happen to you- keep excellent records!