Can your clients qualify for real estate professional status? IRS tests explained

Do your clients qualify for the real estate professional (REP) status, even if they own just one rental property? If so, their activity rises to the level of a trade or business, and losses can be used against ordinary income, such as wages. If they don’t qualify, they will be treated as investors in a passive activity with income limited by passive loss rules.

Lower tax bill in three ways

To be classified as a REP, the taxpayer must satisfy specific criteria, or tests, outlined in §469. Those who meet the IRS’s criteria and materially participate in the business can use rental losses to offset ordinary income, such as wages, rather than be limited by passive loss rules. They may also avoid the 3.8% net investment income tax (NIIT) on investment income, since the activity is considered a trade or business. Finally, the 20% qualified business income (QBI) deduction may be available if the income also meets the standards for QBI.

Statutory requirements and material participation

REPs must meet two statutory participation tests: the more-than-50% and the 750-hour tests. They must also pass one of seven material participation tests for each property unless they are aggregated with other holdings.

The two statutory participation tests are:

1. More than half of the personal services the taxpayer performs during that year are performed in real property trades or businesses in which the taxpayer materially participates (see below).

2. The taxpayer performs more than 750 hours of services during that year in real property trades or businesses in which they materially participate.

   All seven material participation tests are listed in the IRS Publication 925, Passive Activities and At-Risk Rules. However, one test stands out: clients must participate in the activity for more than 500 hours during the year. A different test can be used for each separate property.

Personal services defined

The regulations define personal services as “any work performed by an individual in connection with a trade or business.” [Treas. Reg. §1.469-9(b)(4)] Work must be done by the individual taxpayer rather than employees or contractors unless the taxpayer materially participates in their employees’ work.

Real property trades or businesses defined (partial list)

1. Development and construction/reconstruction: Planning and improving land or buildings for future use or sale
2. Rental: Direct real estate rental operations, including managing leases and tenants
3. Operation: Day-to-day hands-on real property management, such as maintenance and tenant relations or supervising the same

Participation

To meet the participation standard, the taxpayer must perform nearly all the work in the activity for the year, including that done by non-owners. Documentation of hours spent, where and when, is crucial to proving exactly where the client spent time to qualify for the REP status.

Documentation best practices

Court cases reflect the IRS’s insistence on detailed, contemporaneous logs or lists substantiating the taxpayer’s time, rather than on estimates or anecdotal evidence of participation (Bailey v. Commissioner, T.C. Memo. 2001-2).

To substantiate real estate professional status, taxpayers should maintain:

• Contemporaneous logs or time records detailing hours, dates, and descriptions of tasks
• Evidence of material participation includes decision-making records, correspondence or contracts

Tracking material participation with REPSLog

REPSLog is an app built specifically to help real estate investors track the hours, dates and task descriptions commonly needed to support real estate professional status and material participation. Entries can be tied to individual properties and categorized by activity type, with AI-assisted logging to speed up entry. Clients can also track time spent by spouses, contractors, property managers and other participants when relevant. At year-end, they can export clean files to share with their tax professional as part of their REP status or material participation documentation. Try REPSLog on web or a mobile device.