It’s no secret that you got into real estate investing because you saw it as a way to get ahead. Real estate syndications provide Wall Street-independent diversification opportunities, an income opportunity beyond trading your time for money, and, of course, passive income and appreciation in exchange for your well-invested capital.
However, if you’re a high-income earning family, it’s possible that real estate is more than just another investment, but that it’s a way to reduce your tax liability significantly. Sure, you can max out your retirement accounts, donate thousands to charity, and be creative about write-offs. Still, as your income increases, tax deductions phase-out, leaving you with an ever-increasing tax bill and a lot of frustration.
Whether you or your spouse is a physician, attorney, engineer, tech professional, or other high-income earning professional, you may have noticed that as promotions and bonuses are achieved, your taxes keep increasing too!
One reason could be that large companies increasingly employ these high-profile positions instead of them being independent, self-employed individuals with their own practices. Hospital management firms employ physicians, Google, Facebook, and Apple employ engineers and tech professionals, and nearly every large company has in-house attorneys. This shift from being self-employed with your own practice to become a W2 employee means reducing deductions available to you.
Enter REPS – real estate professional status.
In this article, you’ll discover what REPS is, how it may help you drastically reduce your tax liability, and why, in this case, it’s beneficial to have one spouse manage the family’s real estate investments full-time while the other leans into their high-income earning career. So if your spouse is a high-income earner, and you’ve been looking for a way to impact your tax liabilities even though deductions are phasing out, you’re in the right place!
About Real Estate Professional Status
Anyone can claim real estate professional status (REPS) as long as
- More than half the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
This is, of course, lined out in detail in IRS Publication 925, but basically, real estate has to be your primary job. You wouldn’t have much time in a year beyond the 750 hours required for anything besides maybe a part-time job. You don’t need any degree, certification, or license to designate yourself as REPS, and, for a married couple, only one spouse needs to qualify.
REPS allows couples to divide and conquer – one high-income earning spouse gets to lean into their profession while the other claims the REPS designation and assumes responsibility for managing all real estate investments’ day-to-day activities, qualifying the couple for significant tax benefits.
Tax Advantages Of REPS, Plus An Example
Cost segregation studies, accelerated depreciation, and other fancy real estate occurrences often produce on-paper losses for investors, which result in reduced tax liability. Cool, right?
Well, suppose you’re a married couple filing jointly, and you make over $150,000. In that case, you can’t use passive real estate losses to reduce your taxable income because there are no “special allowances” according to the IRS for these high-income families. Those suspended passive losses carry forward until you have a year of passive gains from your real estate investments since passive losses can never offset active income like that from a W2.
That is unless one of the spouses in this theoretical $150K + earning family designates themselves as a real estate professional and meets the qualifications above.
As an example, let’s look at Samantha and her family. Her husband is an executive of a well-known entertainment company, and she manages the household, raises their two-year-old, and oversees the couple’s investment strategy. Her husband, Barrett, makes $250,000 plus bonuses while Samantha manages the day-to-day activities of their real estate investments, which has quickly turned into her full-time job.
Even though her properties are cash flow positive, Samantha generated $150,000 in losses from her real estate business. Here’s where it gets interesting…
Suppose Samantha has designated herself as qualifying for real estate professional status as a couple. In that case, they can deduct all $150,000 in (passive) losses from Barrett’s $250,000 (active) income, leaving only $100,000 reflected as taxable income and dropping them into a lower tax bracket.
However, if Samantha does not qualify or doesn’t designate as a REPS, the couple is taxed on all $250,000 of income, approximately doubling the value owed to their taxes.
Without a REPS designation, Samantha’s $150,000 in passive losses must be carried forward until she has passive gains against which she can apply them. Meanwhile, the couple is taxed on Barrett’s total income, likely for several years.
Why pay more than you have to? Especially considering that any tax savings can be flipped into your next investment opportunity, potentially moving you toward your financial and investing goals faster.
How To Achieve REPS
Now that you can see the benefit of one spouse being the designated real estate professional in the family, you need a plan to put this into action.
First, you’ll need to decide which spouse will become the real estate professional. For some families, this is easy because one spouse is already the primary breadwinner and the other is a homemaker.
For other families where both spouses are working, the choice may be a little more challenging. Beyond each spouse’s current income, consider things like career trajectory, passion for career, passion for real estate, other assumed roles as the real estate professional (child care/homemaker?), and each spouse’s ability to self-propel organizational and management activities.
No matter which spouse chooses to become the real estate professional, they need to be serious about treating real estate investment management activities as a business.
In addition, we suggest discussing this with your CPA so that you can coordinate timing, real estate purchases, designations, and more. From there, set aside funds to invest, start shopping for your first several investment properties, and track your real estate business activities closely.
Use separate bank accounts, an accounting program, a separate email address, and other business-like systems with your real estate investments to further separate and clarify investment management activities from any personal activities.
Making REPS Benefit Your Family
Successfully operating real estate investments and achieving REPS status may look different for every family, so let’s look at a couple of scenarios for clarity:
Scenario 1: Two working spouses, one working full time and leaning into their high-income earning profession, and the other working part-time while materially participating (actively involved) in managing the couple’s real estate investments.
Scenario 2: One working spouse and one homemaker who decides to make managing real estate investments their primary job.
In both scenarios, the spouse managing real estate needs to commit to (and be able to prove) their material participation in the day-to-day decisions regarding their real estate properties, accumulating 750 hours or more of tracked time and activities over the taxable year.
For most, it would be challenging to spend 750 hours on just a few properties. So if you accumulate several properties quickly, track your time and business activities managing them, and treat your investment properties as a business, you’re more likely to achieve all the qualifications for REPS.
Treating investments like a business means having formalities and systems in place, deciding when to raise rents, renew leases, buy, sell, renovate, and more. If you’re constantly approaching your day intending to maximize profit while simultaneously improving your tenants’ experience, tracking your time and activities (a Google Calendar is an excellent tool for this!), and coordinating with contractors toward successful renovations, you’re on your way!
Usually, the 750-hour requirement is per real estate property, but you can combine all of your real estate management activities from several properties into one by including the following language in your tax returns:
Under IRC Regulation 1.469-9(g)(3), the taxpayer hereby states that they are a qualifying real estate professional under Code Sec. 469(c)(7), and elect under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.
That phrase “taxpayer hereby states that they are a qualifying real estate professional” is critical.
Each family is entitled to their own beliefs and opinions about which spouse should work and about the division of labor and responsibilities between the two spouses. Still, if one spouse can hit these requirements, coordinate with tax professionals, and find joy in managing real estate investment assets for the family, REPS can be a huge advantage!
Is Real Estate Professional Status For You Or Your Spouse?
If you’re part of a married-filing-jointly relationship and have an income over $150,000, you may have been feeling increasingly frustrated by your high tax liability. You’ve likely looked into real estate searching for tax benefits, and maybe you are already invested in a few properties.
However, if you want to apply your on-paper losses to your household’s active income, achieving real estate professional status may be the answer. Otherwise, you may be stuck carrying passive losses for years to come.
As always, we’re not here to give you tax or life advice. Instead, take this article and the things you’ve learned here as inspiration for more research, an open discussion with your spouse, and food for thought as you further examine the most efficient way to move toward your lifestyle and investment goals.