Real Estate Professional Status (or REPS, for short) confers some huge financial benefits on whoever can claim it. I often hear it cited as the main reason that doctors or other high income professionals invest in real estate. (I don’t agree with this, but more about that later…)
Regardless, there is also a ton of confusion about what real estate professional status is, how one can obtain it, and what benefits it actually brings.
This does happen to be a topic that Selenid and I know a bunch about and have firsthand experience with. Selenid first obtained REPS for the 2021 tax year. Using Real Estate Professional Status, we were able to deduct massive passive losses from our active W2 income.
Like most things, it is not necessary easy. But it is simple enough when you break it down to its component parts.
So let’s get started.
What is Real Estate Professional Status?
REPS is simply a definition created by the IRS. When you meet the criteria to achieve REPS, that means that you are someone whose main job is real estate. And those people are entitled even more massive tax benefits of real estate.
That’s all it is.
It is not a license that you obtain. You don’t need to become a real estate agent to get it. There are no tests or exams. REPS is just a designation created by the IRS for tax purposes.
How does one obtain Real Estate Professional Status?
Based on the IRS definition, to qualify as a real estate professional you must meet three conditions:
- You worked more than the minimum threshold of 750 hours during the tax year in real property trades or businesses
- Over half of the personal services you perform during the tax year were in your real estate business
- Material participation in these real estate activities
There are actually some other criteria that you can meet in order to qualify for REPS, but these 3 here are the most straightforward and feasible.
And remember, you need to meet each and every one of the 3 above, not just one or two.
Let’s dig deeper
Because there are always a lot of questions.
First, people always ask, “what the heck does material participation mean?”
Well, it’s very vague but this is how the IRS defines it:
Material participation in this context means participation on a “regular, continuous and substantial” basis.
So how’s that for guidance? Not super helpful right?
This is why having a tax advisor who is familiar with real estate investing and its tax implications is so important.
- Some tax specialists don’t know much about REPS. And are scared of it. So they don’t count anything towards material participation.
- Some tax specialists don’t know much about REPS. And they are flippant about it. So they count everything and put you at risk.
So you need to have someone knowledgable. And keep in mind, taxes are a negotiation between you and the IRS. Audits are not arrests. I’m absolutely not saying to cheat on your taxes. But you should be aggressive in using any legal tax reduction strategies available.
If you are wondering, we use Alexis Gallati at Cerebral Tax Advisors as our tax specialist.
Anyway, here are some things that are generally agreed to count for material participation hours towards Real Estate Professional Status:
- Due diligence on a property that you ultimately buy
- Placing and managing tenants
- Fixing items or supervising others fixing items
- Bookkeeping on your properties
- Designing and executing leases
- Anything else that helps your real estate business run
And here are some things that are generally agreed to not count for material participation hours towards Real Estate Professional Status:
- Due diligence on a property that you ultimately do not buy
- General reading and education about real estate investing
- Courses on real estate investing
- Being a limited partner in a real estate deal
- Basically anything where you are not intimately involved with the real estate property
Again, these are not complete definition because complete definitions for REPS do not exist. But they are based on precedent and common sense. Selenid and I are very careful only to count hours that are spent intimately involved in a hands-on way with our real estate investment business. But you better believe we count every single one of those hours that do count.
Is REPS achievable for professionals?
This question is always the next one people ask me. And it really references that first two requirements above:
- 750 hours and
- At least 1 hour more than you spend in any other job
So let’s address the 750 hours first. Is this feasible? Well, yes. Of course it is. It averages out to about 2 hours a day. But it’s rare that it’s that consistent. On many days, Selenid works 0 hours towards REPS. But others, she worked 6+, like when we are placing tenants, doing rehab work, or closing on a property.
We worried it would be hard to reach. But once we made it a goal and began tracking, it was straightforward.
(People always ask us how we keep track. We just have a calendar solely to track REPS hours that she fills out each day. That’s been easiest for us.)
The second criteria above is the challenging one. I would never be able to obtain REPS as a full-time surgeon. Selenid could because she worked this past year as a “fellow,” albeit on a tenure track, in her department. This required a smaller time commitment.
In reality, the most common way for doctors to benefit from REPS is for their spouse to qualify or to cut back hours.
Now that we know what REPS is and how to achieve it, the next logical question is, “What is so great about Real Estate Professional Status?!”
The answer: tax benefits.
Breaking down the tax advantages of Real Estate Professional Status
One of the great things about real estate investing is that you can write off passive “paper” losses against the profits of the investment property.
These passive “paper” losses come largely in two forms:
- Expenses from running the property and
- Depreciation
The government and IRS says that each real estate property loses value each year. In fact, after 27.5 years, the value of any property is $0 in the IRS’ eyes. And this 27.5 years resets every time a property is sold or changes hands.
So, each year, every property you own loses 1/27.5 of its value. This loss in value is the depreciation of the property and is considered a passive loss. You can then use this passive loss to offset passive income – like rental income. You can do this even without REPS.
This is a huge advantage. Especially when you realize that your property didn’t actual lose value but provided immense value as a source of rental income and possible appreciation!
But wait, theres more! You can accelerate this depreciation…
By hiring a cost segregation company to “cost segregate” your property, you can divide items and parts pf your property that actual depreciate to $0 in much less time than 27.5 years.
After the cost segregation is done, you can take advantage of forced appreciation to claim much more depreciation of value for your property. You can use these massive passive losses to offset more passive gains or carry them forward to future tax years.
The problem is that most people don’t have huge amounts of passive income. But they have huge amounts of active income, like from W2 jobs in our case.
This is where Real Estate Professional Status comes into play
By qualifying as REPS, you can now take these massive “paper” depreciation losses and not just offset passive income, but also offset active income like from your W2 job.
In this way, you reduce your taxable income for that tax year immensely and owe way less in taxes!
Watch Jordan’s Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!
But isn’t there a catch?
It’s true. Technically what you are doing is just deferring your taxes. Your tax basis in the property (the amount of value against which the IRS will measure and incur capital gains taxes) lowers itself by the amount of depreciation that you claim. So, if you sell the property in the future, your tax hit will be larger.
But I don’t see this as a huge deal for 2 reasons:
- If you hold onto the property for a long time and leave it to heirs, they get a step up in basis and the tax deferral is never realized
- When you sell, you can use a 1031 exchange to buy a bigger investment property and continue deferring the taxes
- Even if you sell and have to eat the tax bill, you essentially received an interest free loan from the government that you (hopefully) used to further accelerate your investing and path to financial freedom
So far, we have covered the “what,” “how,” and “why” of Real Estate Professional Status.
Now, let’s use an example from our properties
As I mentioned, Selenid obtained REPS for 2021.
We also performed a cost segregation analysis of the 3 properties we owned at that time. This allowed us to take advantage of accelerated depreciation from the properties. That way we take more paper losses from the properties this year rather than spreading it out over the usual 29.5 years.
Counting all properties, we cost segregated $200,000. From just one of the properties, we cost segregated ~$77,000. At a marginal tax rate of 39.6%, this results in roughly $31,000 of tax savings.
In total, at our marginal tax rate of 39.6%, we realized $79,200 of tax savings when you include all 3 properties!
This is obviously huge. And why it was a big part of our annual tax plan that you can review here.
But…and there is a big but…
Accelerated depreciation, which is the real driver of the massive passive losses in real estate, is set to phase out completely by 2027.
In fact, 2022 is the last year of 100% accelerated depreciation. In 2023, investors like us will only be able to count 80% of our total accelerated depreciation as passive losses. It will then continue to decrease down to 0% in 2027.
So, like all good things…this too must come to an end…
Thankfully tax advantages are just one of the reasons real estate investing is so great
Remember, there are 5 ways that you make money in real estate:
- Cash flow
- Appreciation
- Principal pay down
- Inflation hedge
- Tax advantages
So, even if tax advantages become less appealing, the other 4 ways are still humming right along, pushing you towards financial freedom.
And, even despite the massive tax advantages available now, cash flow remains the #1 criteria to consider when buying an investment property. Cash flow protects you from the market and becomes the passive income covering your expenses. So no, tax advantages should not be the main reason you want to become a real estate investor. (But they don’t hurt either!)
If you are interested in learning more about getting started as a real estate investor, I consider these 4 posts to be required reading:
- How To Actually Buy A Real Estate Investment Property
- 3 Best Ways to Invest in Real Estate Without a Crystal Ball
- Powerful Case Study of Passive Hustle in Real Estate Investing
- 5 Biggest Downsides of Real Estate Investing & How to Overcome Them
And if you’d like to brush up on how to screen and analyze real estate properties, check out this post.
What do you think? Do you invest in real estate? Could you obtain Real Estate Professional Status? Let me know in the comments below!
Hi!! Who do you use to do cost segregation studies?
We use Cost Segregation Authority and have had a very good experience!