By default, any tax losses you have from your rental real estate can’t offset your other income, unless you qualify for an exception. One of those exceptions is real estate professional status (REPS). Most rental property owners won’t qualify for REPS, but if you do, you can deduct your real estate losses against your other income. Qualifying for REPS will also exclude your rental income from the NIIT tax—a 3.8% tax on passive income that applies to high-income earners.
If you find that you can’t qualify using REPS, you can also see our article about the ways to deduct your real estate losses.
How to Qualify for Real Estate Professional Status
To qualify, the tax code says that your primary profession must be a “real property trade or business.” The hours must be for a business that you own, or work you do as an independent contractor (which applies to the majority of real estate agents). It can’t be work done as a W-2 employee, unless you own at least 5% of the business.
And there are specific hour requirements for how much time you must spend in a real property trade or business. You must meet all of these requirements:
- More than half of the work you do during the year must be in real property trades or businesses (this is the “50% test”). In other words, real estate work must be your primary job.
- Your total hours for the year spend in those real property trades or businesses must be at least 750 hours during the year (this is the “750 hours test”).
- You must also “materially participate” in each rental property that you want to deduct from your income (more on that in the next section below).
Be aware that if you are a married couple, at least one of the spouses has to meet the 50% test and 750 hours test requirements on their own. You can’t combine spouses’ hours to meet these tests.
The hours requirement is still the same if you started part way through the year in your first year. There is no prorating of hours for the first partial year.
You should keep a log or other documentation of the hours you spend in your real property trade or business in order to be able to show evidence of the hours you spent if it is questioned by the IRS. This was upheld by tax court case Sezonov v. Commissioner, T.C. Memo 2022-40, where the taxpayer’s REPS status was denied because they didn’t have sufficient records to substantiate their time spent.
What activities count towards REPS hours?
According to tax code section 469(c)(7)(C), REPS hours must be a work activity involving “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Examples of activities that do count for REPS hours include:
- House flipping
- Real estate broker/agent
- Building construction trades
- Property management
- Managing a self-storage facility
- Managing your own long-term or mid-term rentals
- Managing your own short-term rentals might count (see below)
Activities that don’t count for REPS hours include:
- Work that is only tangentially related to real estate, such as mortgage brokers, property inspectors, etc. (see IRS Memorandum 201504010).
- Education hours (other than some exceptions)
- Travel time to and from an a work activity
Remember that you must own at least 5% of the business, and it must be a business that you materially participate in. When counting hours for managing your own properties, the types of activities that count for REPS hours are identical to the requirements for the types of activities that count for material participation hours, so for more information on that, see our material participation article.
Do hours you spend managing short-term rental properties count towards your REPS hours?
If you have a short-term rental, it is currently unclear if you can count hours spent on it towards your REPS hours. That is defined as a rental with an average stay of 7 days or less, or if the average stay is less than 30 days and you provide “substantial services” (substantial services means providing things like meals, entertainment, or cleaning services during guests’ stays).
It seems logical that those hours working on your STR would count, but under current Tax Court interpretations of the tax law, an STR is considered to be a hotel/inn business and not a real estate activity. This was upheld by two different tax court cases (Bailey v. Commissioner in 2001, and Todd and Pamela Bailey v. Commissioner in 2011).
But the story doesn’t end there. In January 2021, the “Additional Guidance Regarding Limitation on Deduction for Business Interest Expense” Treasury regulation changes made several changes, including amending the definition of real property trade or business in code section 1.469–9 to expand the definition to include short-term rental type properties (including hotels and motels). That seems to indicate that STR hours would then count towards REPS hours as of 2021. But until that is tested by the courts, it is still be a somewhat risky position to take to use STR hours towards REPS hours.
Material Participation
If you qualify for REPS status, you do still also need to materially participate in the rental property in order to deduct losses from it against your other income.
There are three primary ways most often used to meet the qualification for material participation. You need to qualify for any one of these tests:
- You or your spouse must do substantially all the work to manage the rental. That means you do all the management, cleaning, etc. yourself.
- Or if other people also help with the rental, you have to spend at least 100 hours per year on it, and that must be more time than anyone else. So if you use a cleaner that is going to spend more hours working on the property than you, one solution to that is to use multiple cleaners to keep them under your number of hours. You need to keep a log of the hours you spend on it and the time that other people spend on it also.
- Or if anyone else spends more time on it, then you have to spend at least 500 hours per year. (There is a way to optionally group multiple rental properties together to meet this test.) You need to keep a log of the hours you spend on it and the time that other people spend on it also.
You must meet this material participation requirement for each property that has losses that you want to deduct from your other income. There is an exception if you elect to group your properties together (and in that case you can even include passive syndicated real estate investments). For more detailed information, see our article on material participation.
If you meet the REPS hours qualification, and you also materially participate in the rental property, all of your losses for the rental property can be deducted against your other income.
Tax Code Reference
Real estate professional status is defined in IRC code section 469(c)(7) and is explained in IRS Publication 925.
FAQ
Can qualifying for REPS unlock suspended losses from past years? No. REPS status only lets you deduct losses for the year(s) that you qualify for REPS. Past losses remain suspended until you have other passive income that it can offset. One exception to that, if the same property becomes more profitable and it now produces a taxable income, you can still use the past suspended losses to offset any current taxable profit for that same property (or grouped properties under a grouping election). This is based on tax code section 479(f).
If you have questions about this or other tax topics, or if you’re looking for a real estate CPA or EA with the expertise and knowledge to do your taxes correctly, please contact us.
