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How Real Estate Professional Status Can Benefit Property Owners

by with No Comment Tax, Real Estate, Private WealthTaxAdvisory, Real Estate

Navigating the complexities of real estate taxation can be daunting, especially when aiming to achieve the status of a Real Estate Professional under IRS guidelines. This designation is coveted among property owners and investors due to its potential to significantly reduce how passive activity losses are taxed. Let’s delve into what it means to be a real estate professional, the qualifications required, and the strategic decisions that can lead to tax efficiency.

Attaining the status of a real estate professional offers significant tax benefits, particularly regarding the treatment of passive activity losses. Typically, passive losses, such as those from rental real estate, can only offset passive income, limiting the ability to deduct them from other forms of income. However, as a qualified real estate professional, you can potentially convert these losses into active losses, allowing them to offset ordinary income, including wages and business profits. This can result in substantial tax savings, as it enables you to lower your taxable income effectively. Furthermore, this status can enhance tax planning flexibility, allowing for greater strategic management of income and investments. Ultimately, the designation not only aids in optimizing current tax liabilities but also supports long-term financial growth by preserving more capital for reinvestment and personal use. 

Real estate professional status is also beneficial when considering the implications of the Net Investment Income Tax (NIIT), which imposes an additional 3.8% tax on net investment income for individuals earning above certain thresholds. Typically, rental income is classified as passive, making it subject to this surtax. However, real estate professional status can transform this rental income into non-passive income, thereby potentially exempting it from the NIIT.

This exemption is significant, especially for high-income property owners, as it reduces overall tax liability and preserves more of their rental income. By shielding rental income from the NIIT, real estate professionals can prevent erosion of returns due to this surtax, facilitating enhanced cash flow and greater reinvestment opportunities. Understanding and leveraging this status is, therefore, not only a tactical advantage but a pivotal element in strategic tax planning for property owners.

Achieving the designation of a real estate professional involves meeting specific IRS criteria, which help determine how your rental activities are taxed:

Qualifications for Real Estate Professional Status – To be classified as a real estate professional, you need to meet two primary criteria:

  • Qualification #1 – More than half of the personal services you perform during that yearare performed in real property trades or businesses in which you materially participate, AND
  • Qualification #2 – You perform more than 750 hours of services during that year in real property trades or businesses in which you materially participate.

Thus, a taxpayer who owns at least one interest in rental real estate and who meets the above tests is a real estate professional.

Achieving this requires diligent record-keeping to document hours spent on various activities such as property management, tenant relations, maintenance, and development. Let’s examine the tax meanings of these terms.

Definitions – the following are the definitions of the references included in the two qualifications:

  • Personal Services – Means any work performed by an individual in connection with a trade or business, but not as an investor.
  • Real Property Trade or Business – Is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business. The determination of a taxpayer’s real property trades or businesses is based on all relevant facts and circumstances. Once a taxpayer determines the real property trades or businesses in which personal services are provided, they can’t redetermine them later unless the original determination was clearly erroneous or there’s been a material change of facts and circumstances
  • Material Participation – Material participation is determined by assessing the depth and consistency of a taxpayer’s involvement in business operations. According to IRS guidelines, this signifies more than casual or sporadic participation, entailing regular, continuous, and substantial engagement in the real estate activities. The commitment to these activities must be significant enough to meet or exceed several specific IRS tests. These tests help ensure that the taxpayer plays a crucial role in the property’s management and decision-making processes, thereby distinguishing passive investors from those actively engaged in real estate operations.
  • 500-Hour Test: Spend at least 500 hours per year on significant participation activities (SPAs), with each SPA requiring more than 100 hours individually.
  • Substantially All Participation: Provide substantially all the participation in the activity throughout the tax year.
  • 100-Hour Test: Spend more than 100 hours on the activity, ensuring no other individual spends more hours on it than the taxpayer.
  • Aggregate Time Participation: Spend more than 500 hours across all significant participation activities, which include activities each undertaken for over 100 hours annually.
  • Prior Participation: Materially participate in any five of the last ten taxable years or, for those in personal service businesses, participate materially in any three previous tax years.

Multiple Property Owners – IRS guidelines allow taxpayers to treat multiple rental properties as a single activity for tax purposes. This strategy is particularly beneficial for those aiming to qualify as a real estate professional, as it simplifies meeting the material participation requirements. By aggregating, instead of having to demonstrate involvement separately for each property, you can combine the hours spent across all properties, making it easier to meet the necessary thresholds for real estate professional status.

However, electing to aggregate comes with certain obligations and consequences. Once you choose to aggregate your rental activities, this decision is binding for all future tax years, meaning you must consistently report these properties as a single activity on subsequent returns. This can streamline tax reporting, but it also removes flexibility; if circumstances change or it becomes advantageous to separate these activities, your ability to do so is limited unless you can justify a change under specific IRS provisions.

Failing to elect aggregation when it would be beneficial or not adhering to the consistency requirement can lead to missed opportunities for tax savings and possible scrutiny in case of an audit. Therefore, it’s crucial to carefully consider the decision to aggregate, ensuring it aligns with your long-term investment strategy and tax planning goals. Proper documentation and adherence to IRS rules are essential to leverage the advantages of aggregation effectively.

As you can see, it difficult to qualify and maintain the status as a Real Estate Professional, but if you do qualify the tax benefits can be substantial. Contact this office with questions and for assistance in determining if you qualify. 

Real estate and Gift new home concept,Model house with Red ribbon and key on black background

Gift and Estate Tax Primer

by with No Comment Tax, Real Estate, Private WealthAdvisory, Real Estate

The tax code places limits on the amounts that individuals can gift to others (as money or property) without paying taxes. This is meant to keep an individual from using gifts to avoid the estate tax that is imposed upon the assets owned by the individual at their death. This can be a significant issue for family-operated businesses when the business owner dies; such businesses often must be sold to pay the resulting estate taxes. This is, in large part, why high-net-worth individuals invest in estate planning. 

Exclusions – Current tax law provides both an annual gift tax exclusion and a lifetime exclusion from the gift and estate taxes. Because the two taxes are linked, gifts that exceed the annual gift tax exclusion reduce the amount that the giver can later exclude for estate tax purposes. The term exclusion means that the amount specified by law is exempt from the gift or estate tax.

Annual Gift Tax Exclusion – This inflation-adjusted exclusion is $18,000 for 2024 (up from $17,000 for 2023). Thus, an individual can give $18,000 each to an unlimited number of other individuals (not necessarily relatives) without any tax ramifications. When a gift exceeds the $18,000 limit, the individual must file a Form 709 Gift Tax Return. However, unlimited amounts may be transferred between spouses without the need to file such a return – unless the spouse is not a U.S. citizen. Gifts to noncitizen spouses are eligible for an annual gift tax exclusion of up to $185,000 in 2024 (up from $175,000 in 2023).

Example: Jack has four adult children. In 2024, he can give each child $18,000 ($72,000 total) without reducing his lifetime exclusion or having to file a gift tax return. Jack’s spouse can also give $18,000 to each child without reducing either spouse’s lifetime exclusion. If each child is married, then Jack and his wife can each also give $18,000 to each of the children’s spouses (raising the total to $72,000 given to each couple) without reducing their lifetime gift and estate tax exclusions. The gift recipients (termed “donees”) are not required to report the gifts as taxable income and do not even have to declare that they received the gifts on their income tax returns. 

If any individual gift exceeds the annual gift tax exclusion, the giver must file a Form 709 Gift Tax Return. However, the giver pays no tax until the total amount of gifts more than the annual exclusion exceeds the amount of the lifetime exclusion. The government uses Form 709 to keep track of how much of the lifetime exclusion an individual has used prior to that person’s death. If the individual exceeds the lifetime exclusion, then the excess is taxed; the current rate is 40%.

All gifts to the same person during a calendar year count toward the annual exclusion. Thus, in the example above, if Jack gave one of his children a check for $18,000 on January 1, any other gifts that Jack makes to that child during the year, including birthday or Christmas gifts, would mean that Jack would have to file a Form 709.

Gifts for Medical Expenses and Tuition – An often-overlooked provision of the tax code allows for nontaxable gifts in addition to the annual gift tax exclusion; these gifts must pay for medical or education expenses. Such gifts can be significant; they include.

  • tuition payments made directlyto an educational institution (whether a college or a private primary or secondary school) on the donee’s behalf – but not payments for books or room and board – and
  • payments made directly to any person or entity who provides medical care for the donee.

In both cases, it is critical that the payments be made directly to the educational institution or health care provider. Reimbursements to the donee do not qualify. 

Lifetime Exclusion from Gift and Estate Taxes – The gift and estate taxes have been the subject of considerable political bickering over the past few years. Some want to abolish this tax, but there has not been sufficient support in Congress to do that; instead, the lifetime exclusion amount was nearly doubled as of 2018 and has been increased annually due to an inflation-adjustment requirement in the law. In 2024, the lifetime exclusion is $13.61 million per person. By comparison, in 2017 (prior to the tax reform that increased the exemption), the lifetime exclusion was $5.49 million. The lifetime estate tax exclusion and the gift tax exclusion have not always been linked; for example, in 2006, the estate tax exclusion was $2 million, and the gift tax exclusion was $1 million. The tax rates for amounts beyond the exclusion limit have varied from a high of 46% in 2006 to a low of 0% in 2010. The 0% rate only lasted for one year before jumping to 35% for a couple of years and then settling at the current rate of 40%. 

This history is important because the exclusions can change significantly at Congress’s whim – particularly based on the party that holds the majority. In fact, absent Congressional action, the exclusion amount is scheduled to return to the 2017 amount, adjusted for inflation, in 2026, estimated to be just over $6 million per person.

Spousal Exclusion Portability – When one member of a married couple passes away, the surviving member receives an unlimited estate tax deduction; thus, no estate tax is levied in this case. However, as a result, the value of the surviving spouse’s estate doubles, and there is no benefit from the deceased spouse’s lifetime unified tax exclusion.  For this reason, the tax code permits the executor of the deceased spouse’s estate (often, the surviving spouse) to transfer any of the deceased person’s unused exclusion to the surviving spouse. Unfortunately, this requires filing a Form 706 Estate Tax Return for the deceased spouse, even if such a return would not otherwise be required. This form is complicated and expensive to prepare, as it requires an inventory with valuations of all the decedent’s assets. As a result, many executors of relatively small estates skip this step. As discussed earlier, the lifetime exclusion can change at the whim of Congress, so failing to take advantage of this exclusion’s portability could have significant tax ramifications. 

Qualified Tuition Programs – Any discussion of the gift and estate taxes needs to include a mention of qualified tuition programs (commonly referred to as Sec 529 plans, after the tax code section that authorizes them). These plans are funded with nondeductible contributions, but they provide tax-free accumulation if the funds are used for a child’s postsecondary education (as well as, in many states, up to $10,000 of primary or secondary tuition per year). Contributions to these plans, like any other gift, are subject to the annual gift tax exclusion. Of course, these plans offer tax-free accumulation when distributions are made for eligible education expenses, so it is best to contribute funds as soon as possible. 

Under a special provision of the tax code, in a given year, an individual can contribute up to 5 times the annual gift tax exclusion amount to a qualified tuition account and can then treat the contribution as having been made ratably over a five-year period that starts in the calendar year of the contribution. However, the donor then cannot make any further contributions during that five-year period. 

Basis of Gifts – Basis is the term for the value (usually cost) of an asset; it is used to determine the profit when an asset is sold. The basis of a gift is the same for the donee as it was for the donor, but this amount is not used for gift tax purposes; instead, the fair market value as of the date the gift is made is used.

Example: In 2024, Pete gifts shares of stock to his daughter. Pete purchased the shares for $6,000 (his basis), and they were worth $25,000 in fair market value when he gifted them to his daughter. Their value at the time of the gift is used to determine whether the gift exceeds the annual gift tax exclusion. Because the gift’s value ($25,000) is greater than the $18,000 exclusion, Pete will have to file a Form 709 Gift Tax Return to report the gift; he also must reduce his lifetime exclusion by $7,000 ($25,000 – $18,000). His daughter’s basis is equal to the asset’s original value ($6,000); when she sells the shares, her taxable gain will be the difference between the sale price and $6,000. Thus, Pete has effectively transferred the tax on the stock’s appreciated value to his daughter. 

If Pete’s daughter instead inherited the shares upon Pete’s death, her basis would be the fair market value of the stock at that time (let’s say it is $28,000) and if she sold the shares for $28,000, she would have no taxable gain. 

This is only an overview of the tax law regarding gifts and estates; please call this office for further details or to get advice for your specific situation.