The standard tax treatment of rental properties is that any income or loss generated is considered passive. As a result, any losses associated with rental properties are suspended and carried forward to future years, unless other passive income is available to offset them. Real estate professional status is intended to recognize real estate as a business, provided certain requirements are met. If an individual satisfies the requirements, it can result in a substantial benefit on their tax return.
What is a Real Estate Professional?
A real estate professional is an individual who spends more than half of their time working in the real estate industry. Working in real estate includes businesses where property is developed or redeveloped, constructed or reconstructed, leased, converted, operated, or brokered. In addition, at least 750 hours per year must be spent working in one of these businesses. If an individual is a full-time employee working in the real estate industry, that is not enough to be considered a real estate professional. To meet the requirements, the individual would also have to own more than 5% of the employer’s business. Therefore, a full-time, self-employed individual working in real estate would also meet the requirements to be considered a real estate professional.
Why It Matters
If a high-income individual owns a second home with the sole purpose of renting the property, but does not work in real estate, the individual would not be considered a real estate professional. As a result, the expenses associated with the rental property would be limited to the rental income received from the property on the tax return. Therefore, if the expenses are substantial during the year, the individual would not be able to deduct all of them on the tax return in the same year. Instead, the excess expenses would be carried forward to future years and can be deducted only up to the rental income each year or when the property is sold.
Alternatively, if the same individual meets the requirements for real estate professional status, they could benefit from substantial tax savings. Rather than the expenses being limited to the rental income, this limitation no longer applies. The individual would be able to deduct the expenses associated with the rental property each year, regardless of the rental income. This could result in a substantial reduction in their tax liability each year.
Questions? Ask a WG advisor.
