Uncle Sam’s Gift To A Select Few: IRS Real Estate Professional Status
There's a box you can check on your tax return that can result in no income tax for you or a W-2 earning spouse. Say what?
Tl;dr
Easy to achieve status if you are full-time real estate person; difficult if you are not.
Potential incredible tax benefits if you or your spouse have a W-2 job.
You need a ton of depreciation for it to be most beneficial.
This is a ludicrous tax advantage for the real estate industry. If you can’t beat them, join them.
Disclaimer: This isn’t rocket science to understand, but I’m not a tax professional. I’m just a simple caveman. Consult your tax professional to understand if this tax incentive can work for you.
Real estate people typically don’t have the greatest of reputations with the general public. Is it the awful stories of landlords treating their residents like dirt? The bragging about how they ripped off a mom-and-pop seller for a huge profit? Or is it the absurd tax advantages that Congress has bestowed upon property investors?
Today, I will focus on a tax advantage called “real estate professional” that is incredible for the lucky few who qualify. To all the anti-landlord and pay-your-fair-share folks, please keep your pitchforks and torches at home. I’m just the messenger here.
What Is IRS "Real Estate Professional"?
An IRS Real Estate Professional is anyone that meets the following criteria:
Participates in a real estate profession more than 750 hours in a given tax year.
Real estate is your primary occupation i.e., >50% of your total work time. This is what disqualifies anyone with a non-real estate occupation as you'd have to work about 4,000 hours annually to qualify. (Good luck convincing the IRS you averaged 11 hours per day of total work for 365 days straight.)
There are many websites that go into the details of how this criterion is interpreted by the IRS, so Google to learn more.
So, Who Cares? I Already Deduct Depreciation From My Passive Income
The RE professional designation allows you to deduct depreciation from ORDINARY income, not just passive investment income.
Ordinary income is currently taxed at a higher rate than passive income, so reducing your effective W-2 income is obviously extremely beneficial from a tax standpoint.
Here's an example:
John Rich is a full-time real estate guy. John earned $300,000 income from his W-2 position at a real estate development company and another $300,000 in passive income from his real estate investments. John also had $400,000 in depreciation gained from his investment properties. John's effective gross W-2 income would be $200,000, not $300,000, deferring about $24,000 in federal tax using current federal income tax rates.
The taxable income math is:
$300,000 passive income - $300,000 depreciation = $0 taxable passive income
300,000 ordinary income - $100,000 remaining depreciation = $200,000 taxable ordinary income
$300k Federal income tax due: $19,900 x 10% + ($81,050-$19,901) x 12% + ($172,750-$81,051) x 22% + ($300,000-$172,751) x 24% = $60,042
$200k Federal income tax due: $19,900 x 10% + ($81,050-$19,901) x 12% + ($172,750-$81,051) x 22% + ($200,000-$172,751) x 24% = $36,042
Tax deferred: $60,042 - $36,042 = $24,000 (40% deferral)
John is able to use that extra $24,000 in tax deferred money however he wishes - invest in more real estate, buy Shiba Inu coin, pay alimony to his 9 ex-wives, whatever. John is clearly a savvy real estate investor by taking advantage of the IRS RE professional designation.
The Golden Ticket Scenario
A savvy RE investor can not only earn income for themselves tax free, but they can also potentially get their spouse's income to be tax-free.
For a lucky few, the RE professional status can be an amazing tax advantage for the RE investor that has a spouse that earns a significant W-2 income. Not only can a RE professional apply depreciation to their own W-2 income, but any depreciation that is leftover can be applied to YOUR SPOUSE'S W-2 INCOME to reduce your spouse’s tax basis. You think the world’s greatest inside trader i.e., Nancy Pelosi’s husband, isn’t a RE professional?
What's The Catch?
To make this a useful tax strategy, you need a ton of depreciation in order to offset all your passive income and have some leftover to apply to W-2 income. To get a ton of depreciation, you need to buy a ton of real estate. To buy a ton of real estate, you need a ton of money. Or do you? Yes and no.
Yes, you need a few bucks to buy bigger buildings, but the current tax laws allow you to pull forward to year 1 a significant amount of depreciation by using a cost segregation study, instead of the standard straight-line 27.5 (residential) or 39 (commercial) year schedule. You can effectively get the depreciation benefits of a building that would typically be much larger than you could buy, just by taking advantage of IRS rules available to anyone that bothers to understand them.
The optimal (and very hard to achieve) scenario is the following:
Have a high-income W-2 spouse.
Quit your dead-end corporate W-2 job and focus on buying real estate.
Purchase a large building. (Usually at least $1 million to justify item 4 expense, but generally the bigger the better.)
Hire an engineering firm to perform a cost segregation study that pulls forward depreciation into earlier years. Current tax law allows pulling forward all eligible depreciation into year 1.
Offset all your passive income and use the leftover to additionally offset your spouse's W-2 income.
Pat yourself on the back for doing what the IRS is incentivizing you to do.
Repeat 3-6 for the next year because you probably just used up all your depreciation and need to maintain that sweet “tax-free” life.
There Is No Free Lunch With The IRS
Keep in mind that depreciation will be recaptured by Uncle Sam at the time of property sale. He needs to eat, too. However, the depreciation recaptured that was used to offset higher tax ordinary income, will be taxed at the lower capital gains rate when you sell. Obviously, future tax rates may change, but for now this strategy can be a significant way to reduce your overall tax burden if you are one of the lucky few.
So How Much Tax Is Actually Saved?
Here’s a continuation of the original John Rich scenario:
John Rich deferred $24,000 in taxes. At year 3, he sells the property and has to pay depreciation recapture on the $100,000 of W-2 income deferred in year 0.
Year 0: Federal income tax if we did not use depreciation to defer: $60,042 tax paid
Year 0: Federal income tax if we use depreciation to defer: $36,042 tax paid
Year 3 depreciation recapture: $100,000 x 15% long term capital gains tax = $15,000
Total Federal tax paid for year 0 $300k income: $36,042 + $15,000 = $51,042 tax paid
John was able to save $9,000 by reducing his effective tax rate to 17% from 20%.
This is a simplified, made-up scenario to show how this tax incentive works. Having the ability to compound tax deferral and tax savings over decades can be huge for increasing your net worth.
Please remember to consult your tax advisor on how you might be able to utilize this IRS status. And tax nerds, please fire away with your nitpicks on whatever I got wrong on this.