Real estate investing gives so many tax benefits. There’s depreciation, expenses offset income, and other programs like the 1031 exchange. These are all designed by lawmakers to encourage you, the investor, to put your money into real estate. You need to take advantage of every one you can. The government encourages you to.
One big hurdle that we have as real estate investors is that the IRS considers most real estate investing as a passive investment. The idea is that this way to make money takes very little work and so is passive. While those of us who buy, sell, and manage our own properties would say otherwise, that’s how it is right now.
The IRS considers active investing to be those things that you might substantially do to make your primary source of income. As such, expenses can be deducted from active income sources and this is the thing you are looking for when you want this tax benefit. These include your business expenses like your car and office space.
Active Versus Passive
You want to be able to take any real estate losses and use them to offset your income. But, you can’t do that if you are investing passively. Even though you are schlepping around collecting rent from tenants, the tax man considers this passive – unless certain things apply.
The bottom line: Passive losses cannot be used to offset active income. But you can make your passive income become active income and then gain this significant tax benefit.
How to Become ‘Active’
An active real estate investor is called a real estate professional in the eyes of the IRS. The real estate professional may use the real estate business’s losses to offset other active income. The following must be met to be a real estate professional:
- More than 1/2 of the day-to-day work you do needs to be in real estate business. Consider your day job. You need to do more work in real estate over the course of the year than you do of your day job. This is going to be the deal-breaker for most of us. It’s not exactly clear if that is in time or income, but the IRS will likely look at both. If you are a physician and spend over 1/2 your time on real estate, but 90% of your income is from your medical work, you probably won’t qualify.
- You need to spend at least 750 hours a year on your real estate business. This one is probably not too hard to do.
- Only the active real estate activities can qualify. You might self-manage an apartment building and this might work, but additional investments in real estate, such as being a limited partner in a syndication would still be treated as passive.
If you can make this work, you might need to educate your accountant. You don’t need to get any separate certification from the IRS to be a real estate professional; it’s is just in how you file your taxes. Not a problem unless you get audited. Talk to your accountant before making any changes.
