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  • Writer's pictureMarcus Williamson

Are You Making These Mistakes as a Real Estate Professional?

The real estate professional (tax) designation took on new status January 1, 2013, for investors with rental income. On that date, the net investment income tax (NIIT)of Sec. 1411 became effective, levying an additional 3.8% surtax on all passive income of a taxpayer. An investor with rental income now has an incentive to qualify as a real estate professional: characterizing rental income as active to avoid the imposition of the surtax. Classifying the income as active also has the benefit of being able to net any losses against other forms of active income (i.e. W2 wages) as opposed to only being able to net it against the passive activities the investor may be involved in. As with anything involving the tax code who qualifies as a real estate professional can be nebulous at best and misused at worst. Read to on to make sure you are not making these mistakes.

Top Mistakes to Avoid

1. Not counting the hours

If you have a full-time job in an unrelated industry on top of real estate investing, it will be extremely hard to make the case you are a real estate professional. This is due to the first test that states more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates. This means if you work a full-time job where you put in 2,000 hours per year, you would need to demonstrate that you work 2,001 hours per year on the real estate business.

2. Not counting the hours (again)

To qualify for the designation you also need to materially participate in the real estate business. Material participation is an easier designation - 750 hours in the year. Some investors may laugh at that threshold (it’s not quite 15 hours per week) but others who generally outsource everything and collect their mailbox money could be in trouble. Qualifying as materially participating also brings other benefits but that will be left for another day.

3. Not considering the different investing activities

An additional caveat to the real estate professional designation is you must consider each rental activity separately unless otherwise elected. In many cases, it may be a no brainer to elect aggregation but keep in mind these rules are often misunderstood by taxpayers, tax professionals, and the Tax Court itself. Getting rid of the aggregation is not always easy, either. A taxpayer may revoke the election only in the tax year in which a material change in the taxpayer's facts and circumstances occurs or in a subsequent year in which the facts and circumstances remain materially changed from those in the tax year for which the election was made.

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