A Primer on Real Estate Professional Status for Doctors from SRMD

Dr’s Kenji Asakura and Letizia Alto with the Semi-Retired MD

Summary: Doctors and high-income professionals have few tax advantages due to their high income and employment status. Becoming a real estate professional can provide significant tax savings but is rarely utilized by high-income earners. In this post, we uncover what you need to know about real estate professional status and how to shelter your income using this favored tax status. 

[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article. For the full disclaimer, please see the bottom of the article.]

[2021 update: This article was originally published in March 2018. It is by far our most popular article! In this update, we have added a more in depth explanation of material participation and what it entails. We have also provided the IRS’s criteria for meeting material participation.]

Doctors, like other high-income professionals, have very few tax advantages.

This is due to the fact that most tax deductions are phased out when you earn above a certain level of income.

You’ve probably experienced this when trying to deduct student loan interest or medical expenses only to be told by your accountant that you can’t claim these deductions because of your income level.

Another major factor is their employment status and type of income they receive. Doctors are increasingly being employed by hospitals, so they are paid as W2 wage earners or 1099 independent contractors. This results in fewer deductions compared to a self-employed doctor who has more options for deducting expenses through their medical practice business.

Options for lowering your taxes

While there are several options for lowering your taxes (e.g., starting a business, short-term rentals), we are going to focus on real estate professional status (REPS) because so few doctors are aware it even exists. In fact, when we did an informal poll of doctors, 85% had never heard of REPS.

Even fewer understand the magnitude of the benefit. It’s not something that lowers your tax burden by a few thousand dollars. It has the potential to lower your Federal income taxes to zero if you know what you’re doing!

Download the Quick Guide to Real Estate Professional Status

Benefits of real estate professional status

To demonstrate the magnitude of the benefit, let’s use an example.

Let’s say you are married and make $250,000 as a doctor. Your spouse is a homemaker and qualifies for REPS. In the year your spouse is a real estate professional, let’s say you generate $150,000 in losses from your real estate business.

If your spouse does not claim real estate professional status, you are taxed on all $250,000 and your Federal income tax liability in 2019 according to Smart Asset’s free online calculator is $54,369.

If your spouse claims real estate professional status, you can deduct all $150,000 from your $250,000 clinical income and you are taxed on only $100,000. As a result, your tax liability drops to $16,279.

Your taxable income drops significantly, and you also fall into a lower tax bracket. This is because your taxable income drops from $250,000 to $100,000.

What happens to the $150,000 in losses in the example where your spouse does not claim real estate professional status?

You can’t use any of these losses to offset your W2 income because of your income level. There are no “special allowances” if you are filing as a married couple and make over $150,000 (see IRS Publication 925).

However, you don’t lose these losses. They become “suspended passive losses“ and you carry these forward until you have passive gains (from your rental properties or another source of passive gains) or sell the property.

This could potentially be many years from now as most rental properties operate at a loss on paper (see below for how your property can operate at a loss and at the same time generate cashflow). Therefore, you miss out on any immediate tax benefits. The way we see it, any money you can get from tax savings today can start working for you immediately and get you to your goals faster because of the time value of money.

We often get the question – can you claim these suspended passive losses during a year you become a real estate professional? The answer is “no.” The reason is that these suspended losses are passive and they can never offset non-passive income like income from your clinical job, only passive income.

So it makes sense to be strategic and time your losses so they coincide with the year you become a real estate professional.

How do you qualify for real estate professional status?

Real estate professional status (REPS) is simply a designation that anybody who qualifies can claim on their taxes.

According to the IRS, you qualify if:

• More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.

• You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

In plain language, real estate has to be your primary job. Something you spend more hours on than any other job. If you don’t have another job, there’s a minimum threshold of at least 750 hours that you spend on real estate activities. If you do have another job, you need to be sure that you spend more hours on real estate than your current job.

There is a third criteria that is built into the two criteria above called material participation. This means that you will need to be actively involved in your real estate investments. This entails buying and renting out apartments or commercial buildings and being involved in the day-to-day management of these properties.

You wouldn’t qualify if you are simply investing passively in crowdfunded deals or real estate syndications. Someone else would be doing the day-to-day management of the properties. In other words, you aren’t “materially participating” in your rentals. 

What is material participation?

According to the IRS, “You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

1. You participated in the activity for more than 500 hours.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.

4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.

5. You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.

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

Note that you only have to meet one of the above tests, not all seven. Many of the doctors we work with in our community, choose to meet the first test. Which we refer to as the “500 hour rule.” 

Once you meet the above criteria, your passive losses from rental real estate become non-passive, and you can use these losses to shelter W2 or 1099 income.

A common misconception is that you need a special license or degrees to get this designation. You don’t. Anybody can qualify by meeting the criteria above.

One unique aspect of this tax shelter is that for a married couple, only one spouse needs to qualify, while the other can continue working full-time in their clinical job.

Real estate is an investment that benefits both spouses. 

Examples based on your household situation

Single

As a single person, you have to find a way to make real estate your primary job while you continue to work clinically to pay for daily living expenses. For example, let’s say you currently work around 1,500 hours per year as a 0.75 FTE hospitalist. To qualify for REPS, you would have to spend more than 1,500 hours a year on real estate activities. While you could cut your clinical hours to less than 750 hours, doing so would cut your income in half. This would leave you with less to save for future investments. If cutting back isn’t an option, many of the doctors in our community will take advantage of the short-term rental tax loophole. You can shelter income just like you can with REPS, but you don’t have to cut back at your day job. To learn more about this tax benefit CLICK HERE.

Married with both spouses working

For the spouse who is claiming REPS he/she has to meet the same criteria as the single person above. It’s obviously less of a financial burden for one spouse to cut back on clinical work because other spouse is still making a full-time clinical income. If cutting back isn’t an option, the short-term rental tax loophole is an option as described above.

Married with one spouse working

In this type of household, the spouse who is not working already meets one of the two criteria (real estate can easily become their primary job), so the only other criteria that has to be met is materially participating and spending a minimum of 750 hours/year on real estate.

What are the steps for achieving real estate professional status?

Step 1: Start buying rental properties

Once you make real estate your primary occupation, start buying rental properties so you can meet the 750 hour requirement.

A good place to start is to use the buy and hold strategy for cashflow and focus initially on 2-4 unit multifamily residences. If you want to speed up the process and avoid mistakes, we suggest taking our real estate course, Zero to Freedom. Our course has been taken by thousands of doctors since it was first released in 2019.

Step 2: Materially participate in your rentals

In addition to the hours requirement, you need to materially participate. You might be wondering, what counts as material participation? Unfortunately what counts as material participation is fairly vague. According to Sec. 469(c)(7) of the IRS code, any of the following activities would qualify: “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”

Kenji does all of the day-to-day management of our properties. He knows everything that is going on with each property and makes the important decisions. He decides when to raise rents, when to renew leases, when to renovate, when to buy, when to sell, etc.

When we think about material participation, we take it seriously. We treat our rentals like a business. Kenji cut back significantly and only does a handful of hospital shifts per year. He thinks about his rental business every day with an eye toward maximizing profitability as well as improving the living conditions for our tenants.

In addition, almost all of our properties undergo significant renovation. Kenji works closely with our contractors. He does everything from designing the space, overseeing the work onsite, and problem solving issues that inevitably crop up during a renovation as well as the occasional swinging of the hammer on demo day.

Step 3: Build up your portfolio

Meeting the requirements for REPS with only a few properties for most will be challenging. Therefore, we recommend that you try to acquire several properties as quickly as possible.

It is important to point out that normally, you need to meet one of the material participation tests for each property. However, if you have several properties, there is a ruling that allows you to combine the real estate activities of all properties into one. In order to qualify, your accountant needs to include the following language in your tax returns:

Under IRC Regulation 1.469-9(g)(3), the taxpayer hereby states that they are a qualifying real estate professional under Code Sec. 469(c)(7), and elect under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.

Notice the language: “taxpayer hereby states that they are a qualifying real estate professional.” Your accountant isn’t the one in the line of fire. In the event of an audit, the burden is on you to be able to prove that you qualify for this status. 

Step 4: Track your hours

One of the most important things you should do throughout the process is to track your hours and keep detailed notes of your daily activities.There are many ways to do this, but the most important things is to be consistent.

Kenji keeps track of everything in a Google calendar. He will enter in the time of his appointments or the time it takes to do certain tasks. He’ll also include detailed notes or there will be emails to detail the specific activity. This is one of the reasons it’s important to set up a separate email account for your real estate business. It allows you to easily find all of the correspondence used to manage your real estate business.

Do I need to generate losses in order to get the tax benefit?

The answer is “yes.” You rental properties need to lose money on paper, in order to get a tax benefit.

This may sound counter-intuitive to you. So, the only way to benefit from this tax shelter is to lose money on real estate?

This is the beauty of real estate. It’s often the case that you’ll show a loss on your tax returns while generating positive cashflow from your properties (click here to see a detailed example). Why? 

Taxes are based on net income. This is what you have left over when you subtract all of the expenses from your rental income. Some of these expenses you don’t actually pay for. However, the IRS let’s you claim them on your taxes. These are sometimes referred to as “phantom expenses.”

Depreciation is one example of a phantom expense. It’s the reduction in value of your property from wear and tear that the IRS lets you deduct. It’s not a true expense. Another is the home office deduction. Setting aside a room in your house for a home office doesn’t really cost you anything. Same with phone/internet. You already buy these services for personal use but you have your rental business cover part of the bill.

Including phantom expenses puts your income in the negative territory. As a real estate professional, these losses become non-passive. You can use these losses to offset your W2 clinical income and reduce your tax liability.

There are also ways to expense repairs instead of capitalizing them. These are more advanced strategies that you should discuss with your CPA, preferably a real estate CPA.

Another way to significantly increase phantom expenses is to use something called bonus depreciation. We cover this in detail in another article. In brief, you can claim depreciation on certain building components all in one year, instead of spread out over time. This creates a large depreciation expense that can often shelter a considerable amount of income.

Action plan for achieving real estate professional status

• If you are a couple with both spouses working, decide who will become the real estate professional. Another option is to buy a short-term rental and take advantage of the short-term rental tax loophole.

• Decide how that person will meet criteria for real estate professional status. You have two choices,  cut-back on your clinical job or commit to working more hours in real estate than your clinical job with the minimum number of hours being 750 hours.

• If you are single, you have the same two choices as above.

• If you are a couple with only one spouse working, the non-working spouse will need to commit to becoming a real estate professional. They will need to achieve the 750 hour threshold.

• No matter who claims real estate professional status, what is critically important is to be sure you materially participate. This means you need to be serious about treating real estate as a business.  Involve yourself in the day-to-day management of your rentals.

• Talk to your real estate CPA about real estate professional status and your plans for qualifying for this designation. 

• Commit to investing in real estate with a goal of purchasing as many as possible early on.

• Set aside funds for real estate investing and start investing.

• Track all of your real estate activities very closely.

• Create a separate email account for all of your real estate activities

• Pick a method for tracking your real estate hours and be consistent

• Stay organized and place all documents in their respective folders

• Use an accounting program to keep track of monthly income and expenses.

If you want to speed up the process and learn from us, sign up for our popular real estate course,Accelerating Wealth that focuses in Short Term Rentals (STR’s)