Qualifying as a Real Estate Professional Can Yield Greater Tax Benefits for Property Owners, Investors by Alex Keneiby, CPA
Posted on July 30, 2025
by
Alex Keneiby
Real estate has always been a reliable investment for diversifying one’s portfolio, hedging against inflation and creating a steady stream of passive income from an asset with potential long-term appreciation. Property ownership and management also come with an array of tax advantages that can reduce taxable income and even enable the deferral of capital gains on future sales. However, the best way to maximize the tax benefits of real estate investments is to meet the IRS’s definition of a real estate professional.
Background on Losses from Real Estate Rental Activity
The IRS treats real estate rentals as a passive activity, per se, even when taxpayers “materially participate” in the ongoing property development, management and leasing on a “regular, continuous and substantial basis.” As such, property owners and investors are limited to using net losses generated from passive activities solely to offset income from similarly passive activities, which may also include investments in limited partnerships. They cannot claim passive losses on their tax returns to reduce ordinary income from non-passive sources, such as wages, annuities, investment dividends, interest, and royalties. Moreover, passive activity losses (PALs) are deductible only to the extent that a taxpayer has passive activity income. Any unused PALs must be carried forward for taxpayers to apply against passive income when those passive activities generate a gain or when they dispose of the property in the future.
There are generally two exceptions to these rules. One applies to taxpayers with modified adjusted gross income (MAGI) of $100,000 or less, who may be able to deduct up to $25,000 in rental real estate losses annually. The taxpayer must own at least 10 percent of the rental and make management decisions in a significant and bona fide sense, including management of operating expenses, approving new tenants and deciding rental terms. The second exception to the PAL rules requires taxpayers to qualify as real estate professionals.
Obtaining Real Estate Professional Status
Taxpayers may use passive rental losses to offset non-passive income (thereby reducing overall taxable income) when they meet the criteria to qualify as a real estate professional, which includes:
- spending more than 750 hours during the tax year materially participating in real property trade or business activities, which may include property acquisition, development, construction and renovation; property operations and management; tenant relations; and brokering the property (the 750-hour test), and
- spending more than half of their working hours during the year in connection with a real property trade or business in which they materially participate on a regular and continuous basis (to 50 percent material participation test).
Satisfying both these tests enables taxpayers to fully deduct losses from rental activities against all forms of income, resulting in significant tax savings and improved cash flow that they can use to market and improve their properties, expand their operations and further diversify their property portfolios. For married taxpayers, only one spouse is required to meet these two material participation tests. However, meeting the requisite hours of real estate participation can be challenging, especially for investors who also hold full-time jobs, operate other businesses or own multiple rental properties. These taxpayers must satisfy separate material participation tests for each individual property to avoid the PAL rules.
The good news is that tax laws may provide an opportunity for taxpayers to group together one or more separate rental activities into one larger activity or appropriate economic unit that meets satisfies the material participation tests. Doing so requires a thorough assessment of the taxpayer’s unique facts and circumstances and consideration of the nature of their various rental activities, including the similarities in the types of business they conduct, the geographic location of those entities, the common control or ownership over those trade or business entities and the dependence of each entity on the other.
The onus is on taxpayers to maintain detailed records supporting activity groupings and the exact number of hours they worked to qualify as a real estate professional, including a comparison to the time they spent participating in other trade or business activities. While the IRS does not specify the extent and types of documentation taxpayers must use to substantiate claims of real estate professional status, taxpayers should be as meticulous as possible.
The Potential Tax Savings of a Real Estate Professional
A married couple with a combined W-2 income of $800,000 per year owns a portfolio of 10 rental properties that generate $100,000 in annual losses. If one spouse satisfies the tests to qualify as a real estate professional, they avoid the passive activity loss rules and can deduct $100,0000 from their total taxable income, leaving them with a federal income tax savings of $37,000 ($100,000 loss multiplied by the top marginal income tax bracket of 37 percent). At the same time, they gain the ability to exempt their rental income from the 3.8 percent net investment income tax (NIIT) that would otherwise apply to investment income generated from activities in which the taxpayer does not materially participate.
About the Author: Alex Keneiby, CPA, is an associate director of Tax Services with Berkowitz Pollack Brant, where he provides tax consulting services that guide entrepreneurial clients through complex partnership structures, real estate transactions and issues relating to federal and state taxes. He can be reached at the CPA firm’s Miami office at info@bpbcpa.com or (305) 379-7000.
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