What is a “Real Estate Professional” Under the Internal Revenue Code?
This week we’ll dive into some more technical areas of real estate tax law. As you may know, real estate taxation is mostly governed around court cases and a mish mash of revenue rulings, regulations, and other common/best practices. However, one area of tax law actually is statutory (an actual law passed by Congress!). Among these tax laws, the "Real Estate Professional" (REP) exception under IRC 469(c)(7) stands as an essential tool. But for those located in the Golden State, another layer of complexity is introduced due to California's distinctive nonconformity to certain federal tax laws.
The Overview
The REP exception or IRC 469(c)(7), is a federal tax provision that offers real estate investors an invaluable opportunity. It provides a pathway to categorize rental real estate activities as non-passive. This classification means any losses associated with these activities can be fully deducted against other income types. The potential advantage this can present is significant, potentially transforming your entire tax position. However, unlocking this benefit isn't straightforward - it requires meticulous navigation through a maze of specific requirements.
The Tests
To claim REP status, you must pass two strict tests. The first, known as the "personal services" test, requires that more than half of your personal services throughout the tax year are performed in real property trades or businesses where you materially participate. The second, the "hours" test, dictates that you must dedicate more than 750 hours of services during the tax year to these real property businesses. The devil is in the details - it isn't merely about logging hours; it's about how you spend those hours and your level of involvement in the operations.
Another thing to note is that not all real estate-related activities count towards these requirements. Investor activities generally don't qualify for the 750 hours unless they're directly related to day-to-day management or operations. In other words, perusing property listings or casually discussing market trends doesn't count. You need to roll up your sleeves and dive into the operational side of the business.
Keep in mind, the two tests must be passed in combination together. Also, the hours don’t count if you’re just employed by a company who does real estate services. I’ve seen several examples of disappointed clients who found out that their full time job as a property manager or as a salaried real estate agent (aka a W2 employee) did not count towards the two tests. For it to qualify, they must also have owned 5% of the activity (in that case, the property management company or brokerage they work for) that the hours are being claimed.
California Always Needs Its Cut
This sounds awesome, but if you’re in California, then it gets a little messy. In contrast to federal law, California does not conform to the REP exception. Even if you qualify as a REP on the federal level, California still categorizes your rental activities as passive. Probably because CA is greedy for your hard earned cash. This divergence means you cannot offset non-passive income with passive losses at the state level, a huge departure from federal tax treatment. It's like being a star athlete, but being asked to play by amateur rules when you're on home turf.
What’s interesting about the non-comformity situation is that a typical CA based taxpayer with a substantial real estate activities can have a federal taxable income and as a result, income tax outcome of $0 while also tons of losses to carry over to future years as a result of cost segregation studies. Simultaneously, for California income tax purposes, they can owe a substantial California taxable income number with a reasonably sized tax bill (up to 13.3% in CA) to pay at tax time.
In any event, we’re always here to help you understand and manage these outcomes to ensure that you’re taking advantage of every area of the tax law. Feel free to reach out when you’re ready for a chat!
