Real Estate Investors — Tread Carefully If Claiming ‘Professional’ Status With IRS

I thought it was about time I republished this post — with some additions I hope will help.

The concept as it relates to the Internal Revenue Code is what we’re talking about here. There is an incredible benefit to successfully filing your tax return as a Professional Investor.

It boils down to a simple exemption. Taxpayers owning investment real estate are allowed to use depreciation to ‘shelter’ the income generated from their properties. As usual however there’s a hitch. First though, let’s define depreciation from a practical viewpoint.

It is, plain and simple a fantasy loss, what many have termed a phantom loss. The taxpayer gets to claim a fantasy loss which offsets real income. The common phrase used to describe depreciation is tax shelter. Also, once all the property’s income is covered, the remainder, if there’s any depreciation left, is allowed to offset your ordinary (read: day job) income. This results in paying less income taxes. In other words, it’s another form of cash flow.

How cool is that!?

Back to the hitch. The key word here is Tax. Sheltering it or paying it.

Regardless of how much depreciation you as an investor have, the IRC caps its use against your ordinary income at $25,000 annually. Wait, that’s not all. The more you need it, the faster they take it away. Uh, duh, it’s the government. It’s not their job to make us happy. Once your ordinary income exceeds $100,000 they begin decreasing the maximum $25,000 until you get to an income of $150,000 — by which time you’re not allowed any use of depreciation to reduce ordinary income. Don’t be confused here. This limitation applies only to your ordinary income — not the cash flow income from your real estate investments.

The sighs I just heard tells me reality just sunk in for some.

To review — you get $25,000 a year in phantom losses (depreciation) up ’till you make $100,000. It then begins to fade away ’till it’s eliminated from your world at the point your annual income reaches $150,000.

There’s a way to get around it — but it ain’t easy.

All you gotta do is say yer a real estate professional. Once you’ve successfully received the IRS’s blessing as a Pro Investor Dude (Dudette?) the $25,000 limitation is lifted, along with any ordinary income limitations. Let me make as clear as a spring sky in San Diego at noon.

As a Pro Investor you can make an unlimited amount of income and take an unlimited amount of depreciation (phantom losses) against that income.

Wowie wow wow wow. The coolest of the cool.

Got a million bucks in ordinary income and a million bucks in depreciation? Do the math.

This doesn’t take into account all the other tax laws that whipsaw us back and forth reminding us why our Forefathers gave us the 2nd Amendment. Don’t go around quoting me — check out what I’m saying here with yer own tax guy. This isn’t some hidden or little known factoid I’m trotting out here. That said, just like the Alternative Minimum Tax has for years taken away much of what the rest of the IRC gives — ensure you’re acting with complete confidence and massive professional expertise behind you.

The IRS has a whole bunch of tests to see if you qualify for the designation. I’m a full time real estate broker which some would say is the gold standard. Nobody qualifies easier than a full time real estate broker who also owns his own real estate investment firm. The only bet safer than that is the sun setting in the west.

Here’s a summary, not all-inclusive, of how you might qualify for the designation.

1. Does a company engaged in a real estate activity in which you own 5% or more of the company currently employ you?

If the answer is yes, you are a Real Estate Professional.

If the answer is no, continue with 2.

2. Do you work outside of the home?

If the answer is no, then go to 4 below.

If the answer is yes, go to 3 below.

3. Do you spend more hours in real estate activities on an annual basis than you do in your other business?

If the answer is no, then you cannot qualify as a Real Estate Professional.

If you’re married and file a joint return, have your spouse complete this portion of the questionnaire.

If the answer is yes, then go to 4 below.

4. Do you spend a minimum of 750 hours per year in real estate activities?

If you answered yes and have no other profession, you are a Real Estate Professional.

If you answered yes and passed the test of 3. above, you are a Real Estate Professional.

If you answered no, you cannot be a Real Estate Professional.

Please, I beg you, don’t use this as the last word on the subject, ‘cuz I guarantee you it ain’t. But if it appears you might easily qualify, i’d urge you to follow it up with a call to your CPA or tax attorney. I’m neither.

The trap is set when folks see this as an easy workaround for tax reduction. That is a stainless steel bear trap that will cause IRS pain you don’t want in your life. Take my word here — talk with your tax advisor to see if you might qualify for this. If you claim this designation and it’s disallowed, you’ll wish you’d stepped in a bear trap instead.

I currently deal with many clients who’ve successfully cleared all the IRC hurdles for this coveted designation. Here’s one example.

He was an attorney — quit his job to become an investor — and now he’s a recovering attorney. He easily passes the required tests and has qualified to file his tax returns as a Professional Investor for years now. It’s made a pretty big difference in his life — especially around the middle of each April.

A final note

The motivation for this post was the recent proliferation of so called ‘advisors’ who were counseling folks to claim the designation while kinda sorta telling them to seek expert advise or consultation. By the fourth or fifth time I read one of these hacks, I felt this post was necessary.

Go ahead and explore the subject with a CPA or tax attorney — it’s worth a try.

Please, as a favor to me and yourself, don’t read somebody’s claims on the internet and go for it. Those bear traps are as nasty as they appear to be.

Another nasty trap is laid by investors themselves. These traps appear when there’s no Purposeful Plan to show the way. Let’s talk — 619 889-7100 or write me using Contact BawldGuy. Have a great weekend.

Related posts:

1. Tax Shelter — Real Estate Investors Should Beware the Professional Investor Trap
2. Adjusted Basis: It Ain’t Just ‘Buy Low & Sell High’ For Real Estate Investors
3. Beginning Real Estate Investors — Stop Lookin’ Forward To April’s IRS Refund
4. Purposeful Planning And Tax Shelter For Real Estate Investing
5. California Real Estate Investors Using 1031 Exchanges To Turbo Charge Portfolio