How to Become a Real Estate Professional (REPS)

Becoming a real estate professional (REPS) can provide you and your business with some amazing benefits.  Qualifying can enable you to significantly reduce your tax liability which can enable you to grow your business at a rapid rate.  

What is Real Estate Professional Status (REPS)?

Real estate professional status (REPS) is an IRS-designated tax treatment that allows investors to take advantage of significant tax benefits. These benefits include deducting real estate losses against other income and potentially avoiding the net investment income tax. However, an investor must meet the qualifications we'll discuss below.

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REPS Qualification 

The IRS lays out specific provisions on how to qualify for REPS.  On the surface, they don’t seem that difficult to achieve, but as you dive deeper into IRS Publication 925, you begin to see the potential complexities of qualifying as a REPS.

To qualify as a REPS for any given year, you must meet BOTH of the following requirements:

• More than 50% (ie, 51%) of your personal services you perform (in all trades or business) during the tax year were within the real property trades or business

If you work 1000 hours at a hardware store and 1000 hours in real property trades or business – you wouldn’t qualify as it has to be more than 50%

• You must work at least 750 hours in the real property trade or business

AND

• The hours that you put forth to qualify must constitute those that you have “materially participated” (more on this in a moment)
  
  

What Qualifies as Real Property Trades or Businesses?

So, what counts as a real estate trade or business? 

Development or Redevelopment

This can relate to building property on land or converting something or a property into a rental.  Alternatively, it could specifically relate to the conversion of a long-term rental into a short-term rental.

Constructs or Reconstructs it

The actual act of building or remodeling or rehabbing a property.  Specifically, this would be obtaining permits, dealing with architects, doing design work, interior design work, or anything to improve the rentability of the property.   Alternatively, it could be simply dealing with the contractors or individuals who actually “touch” or “work on” the properties.

Acquires it

Basically anything you do to help you acquire a property – performing due diligence research, dealing with real estate agents, wholesalers, management companies, home inspectors or appraisers.  

Converts it

Essentially, it would be converting a room or area of a property into a serviceable rental space.  

Rents or Leases it

Typically this is performed by property managers; however, if you are doing work to acquire tenants for your rental properties then this could suffice.

Operates or Manages it

In its basic form, this would be dealing with tenants’ leases (and associated documents) as well as the ongoing management of the property, complaints, repairs etc.

Brokers it

The act of selling of acting as a broker in the real estate world. 

Now that we understand the number of hours and the percent time working in what the IRS qualifies as real property trade and businesses, we get to the matter of “materially participating”.

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What is "Material Participation"? 

To “materially participate” per IRS Publication 925, the taxpayers must satisfy one of the seven material participation tests.

#1 – Participate in more than 500 hours

#2 – Activity that constituted all participation substantially

#3 – More than 100 hours of involvement and no less participation than any other individual

#4 – The activity is a significant participation activity for the tax year, and the individual's participation exceeds 500 hours

#5 – Participation in five of the preceding 10 tax years

#6 – The activity is a personal service activity, and the individual materially participated in the activity for any three tax year

#7 - Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

Benefits of Real Estate Professional Status

We’ve spent a lot of time summarizing the necessary pieces to “qualify” as a REPS – but why go through all of the effort?

Quite simply – the huge tax benefits.  And I mean potentially huge.  

To start, rental activities are considered passive activities even if you materially participated in them.  From a tax standpoint, this means that the losses incurred are only deductible against passive activity income.  If the passive losses are more than the passive income, then the loss is carried over to the following year.

BUT……

If you qualify as a REPS, the passive activity loss rule doesn’t apply and the losses incurred through rental activities can be offset by nonpassive income – like wages from your W-2.  Which can be tremendously beneficial for high W-2 income earners.  

For married couples only one person has to qualify for REPS to reap the benefits on the married-filing-joint return.  Which means that one spouse can have a high-income W-2 job while the other qualifies as a REPS to offset the income.  

You can further maximize our losses against you active income by performing a cost segregation study which accelerates the depreciation of your rental property.  You don’t receive a higher cumulative deduction for depreciation but instead of spreading it out over 27.5 years you can frontload the deduction.  Which can, in some cases, remove a significant portion of your active taxable income.  

Despite the IRS laying out guidelines on how to qualify as a REPS, there isn’t a method to apply or process.  In fact, it is on the individual to provide documentation (through logs) of their qualifications if they are ever audited.  It is prudent that the individual provide the necessary information and justify why they qualify as a REPS.

Finally, for investors who own multiple properties it is imperative to aggregate all of your real estate activities under REPS as opposed to qualifying on a per-property basis.  This enables you to utilize all materially participated hours towards REPS as opposed to obtaining it with each individual property.

REPS Steps Review

Want to qualify? Follow the below steps: 

1. Participate in real property trade or businesses 51% of our time
2. Have at least 750 hours of material participation in real property trade or businesses
3. Log your activities
4. Include a form that aggregates all of your activities and properties

Qualifying as a REPS can have huge implications on your overall tax burden, which can lead to the ability to grow your real estate business.  While the IRS lays out the guidelines, it is important that you, as the investor, know and follow their guidance.  There isn’t a method to check if you qualify until you are being audited by the IRS, so it’s important to be confident that what you log is, in fact, per their standards.

Given the potential upside to qualifying as a REPS, it is important to utilize experienced professionals to ensure that you meet the tests for qualification.