Tax Strategy Tuesday: Real Estate Professional Tax Strategy

A few weeks ago, I talked about one way to get big real estate tax deductions onto a tax return, the vacation rental tax strategy.

This week, I discuss a second way to qualify for big deductions. The real estate professional tax strategy.

If you’re a high-income taxpayer who wants to put big real-estate-related tax deductions onto a tax return? Yeah, this is an option you want to consider. Further, now, at the very beginning of a new year, is the time you want to start using this strategy.

But let’s dig into the details…

Note: We been blogging every Tuesday about tax strategies. Click here to see the complete list: Tax Strategy Tuesday.

Real Estate Professional Tax Strategy in Nutshell

The real estate professional tax strategy works mostly because of the depreciation deduction an investor enjoys.

Suppose you purchase a rental property for $1,000,000. Perhaps using a $100,000 down payment and a $900,000 mortgage. Say the tenants pay you $60,000 of annual rent. Suppose that amount covers the operating expenses and even pays the mortgage payment.

In economic terms, this arrangement may work beautifully. The property may be appreciating. The steady mortgage payments may over time pay off the loan. Probably, you’re making money.

But tax accounting rules allow you to add a large depreciation deduction to your return. In other words, even though your investment may slowly be growing in value, you can write off a loss each year on the property. Maybe, in fact, around $30,000 annually for a property like the one just described?

The problem is, most high-income investors don’t get to use that large depreciation-derived tax deduction. (Middle-class investors do by the way.)

Example: George and Martha earn $200,000 from jobs and own an investment property that generates a $30,000 loss due to depreciation. They would like to use the $30,000 loss to shelter some of their earned income. But they cannot. Tax laws limit their passive loss deductions.

Tax laws allow some taxpayers to use these passive losses, however. And one group who can? Real estate professionals.

Example: John and Abigail also earn $200,000 from jobs and also own an investment property that generates a $30,000 loss. John and Abigail can use the $30,000 loss to shelter some of the income they earn in their jobs. And the reason? Because John qualifies as a real estate professional.

Tricks that Make Real Estate Professional Tax Strategy Work

The trick to making the real estate professional tax strategy work? Qualifying as a real estate professional.

Essentially, tax law looks at two things.

First, does a taxpayer or one of the taxpayers on a married joint tax return work in  “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Tip: By the way? The key word to pay attention to in the quoted language (which comes from the statute)? The word “any.”

Second, to qualify as a real estate professional, an individual must:

1. Spend more than fifty percent of their work time in the real estate trade or business.
2. Spend more than 750 hours working in the real estate trade or business.
3. Materially participate in the real estate investment generating the passive loss.

One final note about working in a real property trade or business. An individual qualifies as working in a real property trade or business if she or he owns a sole proprietorship or is a partner in a partnership that, for example, does development, construction, rental, management, or brokerage. And an individual qualifies as working in a real property trade or business if she or he works as an employee of a corporation and owns five percent or more of the business.

Example: John and Abigail, the married couple mentioned in the preceding example, show $200,000 of income from jobs on their tax return and a $30,000 real estate loss. They get to deduct the $30,000 loss because John qualifies as a real estate professional. One way John might qualifiy? If he owns more than five percent of a corporation that operates a construction trade or business.

Possible Tax Savings from Real Estate Professional Tax Strategy

Structured correctly, a large depreciation deduction or a collection of deductions often shelters other highly taxed income a taxpayer earns.

Example: A single, self-employed real estate broker earns $300,000 working full-time at his business. He also invests in real estate properties and materially participates in their operation. As result, any loss generated by the investments shelter his income. If an investment breaks even in terms of cash flows but generates a $100,000 loss due to depreciation, for example? He nets the $300,000 of broker earnings with the $100,000 of the rental losses. The result? He pays income taxes on $200,000 and so probably annually saves $30,000 to $40,000 in federal and state income taxes.

If a married couple files a joint tax return and combines a high-earner with a real estate professional, the tax return can use real estate losses to shelter the non-real-estate-professional’s income.

Example: A married couple includes a high-earning spouse who makes $1,000,000 in a W-2 job and a spouse who works half time (so roughly 1,000 hours a year) managing the family’s rental property portfolio. The rental portfolio generates a small positive cash flow but on paper due to depreciation shows a $400,000 loss each year. The couple pays taxes on the $600,000 net income and probably saves about $150,000 in federal and state income taxes.

Turbocharging the Real Estate Professional Strategy

Typically real estate investors depreciate commercial property over 39 years and residential property over 27.5 half years.

If an investor buys a $1,000,000 property that represents $200,000 of land and $800,000 of building, the investor depreciates just the $800,000 of building.

To calculate the annual depreciation for an $800,000 commercial building, the investor divides the $800,000 by 39 years. So nearly a $20,000 annual depreciation deduction.

To calculate the annual depreciation for an $800,000 residential property, the investor divides the $800,000 by 27.5 years. So roughly a $30,000 annual depreciation deduction.

Taxpayers interested in larger deductions, therefore, may wish to focus on residential properties.

Further, tax laws do provide real estate investors with a trick to load more depreciation into the early years of ownership: cost segregation.

Cost segregation breaks down the building part of the property’s cost—so $800,000 in the preceding paragraph—into real property (depreciated typically over 27.5 or 39 years) and personal property (depreciated very quickly and maybe even mostly in the first year or two of ownership).

A $800,000 apartment building for example might be cost segregated into $600,000 of real property that the taxpayer depreciates over 27.5 years and $200,000 of personal property depreciated mostly over the first year or two of ownership.

Limits to Strategy

Starting in 2021, however, tax laws limit the excess business losses a taxpayer deducts in any one year to the amount of trade or business income shown on the tax return plus another $262,000 in 2021 and $270,000 in 2022 if unmarried or $524,000 in 2021 and $540,000 in 2022 if married.

This limitation means that the highest income taxpayers can’t always shelter all their W-2 income via the real estate professional tax strategy.

Example: A married couple includes an executive earning $2 million annually in W-2 wages and a spouse who manages the family’s real estate rentals. The property manager spouse qualifies as a real estate professional. And the rental portfolio loses (on paper) $1 million annually. For 2021, the couple however can only use $524,000 of real estate losses to shelter the W-2 income.

How This Strategy Can Blow Up

When it fails, the real estate professional tax strategy fails for one of two reasons. First, it fails because careless or poorly informed taxpayers lose some of their hours. Those lost hours? Investor activity hours when a taxpayer isn’t involved in daily operations. And property manager hours when a taxpayer hires an outside property manager.

Example: Thomas spends 1000 hours working in his real estate trade or business. That amounts to more than fifty percent of the time he works in a trade or business. Accordingly, he assumes he qualifies for the real estate professional tax strategy. Unfortunately, because he doesn’t get involved in daily operations of the properties, he cannot count 150 hours of investor-type activity. Further, because he hired an outside property manager, he cannot count 150 hours of property-management-type activity. With only 700 hours counting toward the 750-hour minimum threshold, he fails to qualify for real estate professional status.

A second reason the real estate professional tax strategy fails? Because an investor fails to create a time log that an auditor accepts. This is a sort of an unfair trigger to failure. The tax laws suggest a reasonable approach to the recordkeeping works and that estimates are okay. Auditors, however, often seem to want extremely high quality contemporaneous time records as well as third-party proof.

The Real Estate Professional Strategy Works Best for These Taxpayers

The real estate professional tax strategy works well for full-time real estate agents, brokers, and property managers who want to also directly invest in real estate.

The strategy also works well for individuals who own and operate real estate trades or businesses. So, like construction company owners.

Finally, high-income married couples can often make the strategy work extremely well. If one spouse earns a large income (say $1,000,000) and the other spouse manages the couple’s rental portfolio and generates large paper losses due to depreciation deductions (say $500,000 a year), the spouses can dramatically reduce their income taxes by netting the W-2 wages with real estate losses.

Other Information Sources

The passive loss limitation rules and the material participation rules get covered in depth in the Treasury Regulations for Section 469. That information merits close scrutiny.

We’ve also got some blog post that discuss in more detail how the real estate professional trick works, how investors count real estate hours, and how the IRS audits real estate professionals. That information should also be useful to people learning more about this gambit.

Finally, and as always, taxpayers want to discuss a strategy like this with their tax advisor. He or she knows the details of your specific situation. And this plug for our CPA firm: If you don’t have a tax advisor who can help, please consider contacting us: Nelson CPA.