Real estate professional status (REPS) can unlock massive tax benefits, even for full time doctors. Is it too good to be true? Do you qualify? Read below to find out.
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There was a golden age of physician real estate investing, and it isn’t now. It was in the early 1980s. If you were a physician in that era, you could work full time, buy a passive real estate investment, and deduct all your paper losses from that business from your active income. It was the best tax shelter since sliced bread, and many savvy physicians sheltered their physician income in this way.
This all came to an end in 1986 with the passage of “passive activity loss rules” with IRS Code 469. Basically, this code changed the game so you could only deduct losses from rental real estate investing if you were materially participating in the real estate business. The code also applied to other forms of passive income, but was particularly strict with rental real estate.
Why it matters
When this IRS code passed, I was in kindergarten. I was happily building wooden block castles, taking naps, and eating graham crackers with milk. But if I knew then what I know now, I probably would have started crying.
Because this is a huge deal. Prior to the passage of this code, you could effectively shelter your entire clinical income by just pushing money into passive real estate investments. You could invest your money from your day job into a passive real estate fund, get a good return, and also get tons of deductions to reduce your taxable income. Talk about a good deal!
How to generate income yet still show a loss
There are many ways that real estate investment can generate a “paper loss,” yet still generate wealth.
Depreciation is a primary example. This is from the concept that all physical structures degrade and lose value over time. The IRS lets you deduct a certain percentage of that degradation every year against the income generated from your rental property. This is despite the fact that most real estate will actually gain value over time via appreciation.
Check out this post for an overview of the tax benefits of real estate investing.
In later posts, I’ll touch on concepts like accelerated depreciation that can front load tax benefits from depreciation into the first few years of ownership.
Real estate professional status
There are exceptions to every rule, and Code 469 has an exception as well. The exception is called Real Estate Professional Status (REPS). It exists because some people actually spend the majority of their working hours creating, developing, and managing rental real estate deals. For these people, it makes sense that losses from their primary business should be tax deductible.
The tests to claim real estate professional status
You don’t just get to claim REPS because you feel like you deserve it. You have to pass two specific IRS tests in order to claim this status. If you’re claiming REPS for your rental real estate business, you have to prove that you materially participate in the business, and that:
- More than half of your work hours during the year are spent in your real estate business
- Over the course of the year, you spent more than 750 hours working on your real estate business
Explanation of test #1: the 51% rule
This test is a stumbling block for anyone working full time. Let’s say you work 40 hours a week in your day-job, yet try to claim real estate professional status. Basically, you’re saying that you also work at least 41 hours a week in your real estate business.
Eighty one hours of work a week? That’s a lot of hours! When do you sleep or go to the bathroom? Who do you think you are, a surgery resident?
In fact, there’s a ton of case law showing how the IRS loves to scrutinize claims of real estate professional status when the taxpayer works a full time job. They make it really tough.
Explanation of test #2: the 750 hour rule
This is a base level of annual hours that the IRS deems necessary to spend in your real estate business for you to qualify for REPS.
If you divide 750 by 56 weeks in the year, that means you’re spending at least 13.4 hours a week working on your real estate business. That’s 2-3 hours a day, Monday – Friday.
And it’s not just any hours that you get to count for the 750 hours. They have to be spent doing things that demonstrate “material participation” in the rental business. More on this below.
Considering the rules together
Basically, you have to work at least 750 hours a year on your real estate business, and this has to be MORE than the amount of time that you’re working in another job.
Your main line of work, therefore, actually has to be real estate, to be considered a real estate professional. Makes sense, right?
You may find yourself losing interest at this point. “I’ll never be working few enough hours to qualify for REPS,” you may be thinking.
But wait, are you married? All might not be lost.
A perk of marriage
Interestingly, the IRS rule specifically states that EITHER spouse can satisfy the requirements. So an ideal scenario might be a physician and non-working spouse. The non-working spouse can gain the 750 hours of material participation, and then ALL the paper losses from the real estate business can be deducted from the joint family income.
Woohoo, it’s the 1980s all over again!
Defining material participation
The obvious question is: how exactly do you demonstrate “material participation” in the rental business? Remember, without materially participating in the real estate business, you can’t claim REPS even if you meet the first two tests.
There are of course specific ways to demonstrate this. Read this excellent post for more on the 7 tests to demonstrate material participation.
Does thinking about real estate count? How about researching properties? How about driving to and from your rental properties? There are a million and one ways to spend time on real estate, and therefore this is an area of significant variation based on your accountant’s interpretation of the IRS guidance.
As always, if you’re actually going to do this, I highly recommend you talk to an accountant who specializes in real estate.
An example: The Smiths
So what’s the big deal about REPS? Let’s look at a simplified example to find out.
Dr. Smith is a psychiatrist and real estate investor. She makes $250,000 a year, and over the last decade has saved a full year’s salary for investments.
Her husband is a stay at home dad and is interested in real estate investment also. Together, they decide to purchase a $1 million multi-family building. Mr. Smith spends considerable time researching the property and coordinating the purchase and renovation of the units. He then decides to self manage the rentals. Over the course of the year he spends > 750 hours materially participating in the real estate rental business and qualifies as a real estate professional.
They talk to a CPA who advises them to perform a cost segregation study and use accelerated depreciation to deduct a large percent of the value of the building in the first year of service.
After the cost segregation study, they’re allowed to deduct $250,000 of paper losses from Dr. Smith’s active income that year. They pay no income taxes that year!
They normally would have paid over $40,000 in taxes, but instead they have this cash to save for their next real estate investment.
The next year, their multifamily property produces $80,000 a year of rental income, and Dr. Smith starts taking one day off a week. She sees her kids more, starts doing yoga, and loses that horrible sense of burnout that’s plagued her for the last few years.
Real estate professional status (REPS) is an incredibly powerful way to shelter active income from taxes. As you read above, it’s not easy to get this tax designation without careful planning. But if you can justify it, REPS can be a really powerful tool to accelerate your investing journey.
When it comes to my family, I work full time and the Dr-ess has no interest in going part time. So the incredible tax benefits of REPS will remain out of our reach for now. There are some interesting ways to get some of the benefits of REPS via a short term rental business, which has been increasingly on my mind these days.
More to come on this soon, so stay tuned!
For real estate investors, talking about REPS is super fun. No worries if it’s confusing and boring for now. I’m sure you’ll come around. Please subscribe for more content and comment below!
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