You've probably heard about the tax benefits and passive income that come with real estate investments, and how they're different from traditional Wall Street investments. But here's the twist: when it comes to high-income earning professionals like doctors, things get a bit more interesting.
High income often means high tax bills, and navigating the complex world of tax laws can be challenging. Even if you're diligently maxing out your retirement contributions, making charitable donations, and exploring different write-offs, your income can still push you into a higher tax bracket. It's like having a party for your achievements, but the looming tax bill can put a damper on the celebration.
However, there's a game-changer you might not have heard of – Real Estate Professional Status (REPS).
In this article, we'll dive into what REPS is all about, how it can significantly impact your tax liability, and why it might be beneficial for one spouse to manage your family's real estate investments full-time while the other focuses on their career. If you're a high-income earner looking to reduce your tax burden, even as deductions phase out, you're in the right place!
How Does REPS Help High-Income Earning Families?
Let's talk about how REPS can be a game-changer for families with high incomes. You see, real estate investments often generate paper losses through depreciation, cost segregation studies and accelerated depreciation. These paper losses can reduce your tax liability – which sounds pretty cool, right?
But here's the catch: if you're a married couple filing jointly and you make over $150,000, you can't use these passive real estate losses to lower your taxable income because there are no "special allowances" according to the IRS for high-income families. Those losses stay suspended until you have a year of passive gains from your real estate investments.
Now, imagine if one spouse qualifies as a real estate professional. This changes everything.
Consider Dr. Aguilar and her family as an example. Dr. Aguilar makes a $350,000 a year, while her husband manages their real estate investments full-time. Even though their properties are making money, they generated $150,000 in "paper losses" from the real estate business (from depreciation, etc). Here's where it gets interesting.
If her husband qualifies as a real estate professional, they can deduct the entire $150,000 in losses from Dr. Aguilar's income, reducing it to a lower tax bracket; leaving only $200,000 reflected as taxable income and dropping them into a lower tax bracket. But if her husband doesn't qualify, they're taxed on the full $350,000 income, which could double their tax bill.
What Is Real Estate Professional Status (REPS)?
REPS allows couples to divide and conquer – one spouse focuses on their high-income career while the other claims the REPS designation and manages all real estate investments' day-to-day activities, unlocking significant tax benefits.
The beauty of REPS is that there's no test to pass, formal certification to achieve, or degree to earn. Anyone can claim REPS as long as they meet two criteria:
More than half of your work in all businesses during the tax year was in real estate property trades or businesses in which you materially participated.
You performed more than 750 hours of services during the tax year in real estate property trades or businesses in which you materially participated.
In simpler terms, real estate should be your primary job, and there's not much time left in a year beyond the 750 hours needed for anything else.
How To Achieve REPS
Now that you see the benefits, it's time to put REPS into action. First, decide which spouse will become the real estate professional. Remember, neither spouse can have a full time job and manage real estate full-time.
For some families, this decision is easy if one spouse is already the primary breadwinner, and the other stays at home. In other cases, where both spouses work, the choice might be more challenging. Consider factors like income, career passion, real estate enthusiasm, and each spouse's ability to handle their designated role effectively.
Regardless of who becomes the real estate professional, they must treat real estate as a serious business. Discuss your plans with your CPA, coordinate timing, investments, and tax filings, and set aside funds to start your real estate journey.
Treat your real estate activities like a business by using separate bank accounts, accounting software, and a dedicated email address. Anything that separates your real estate activities from personal ones and provides a clear record of your 750 hours spent is a valuable step.
Making REPS Work for Your Family
Every family is unique, so let's look at two scenarios:
Scenario 1: Both spouses work, with one focusing on their high-income profession and the other working part-time while actively managing real estate investments.
Scenario 2: One working spouse and one homemaker who becomes the primary real estate person.
In both scenarios, the spouse managing real estate must commit to proving their material participation in day-to-day decisions, accumulating at least 750 hours of tracked time and activities during the year.
For most, it's challenging to spend 750 hours on just a few properties, so if you accumulate multiple properties quickly, track your time, treat your investments as a business, and make decisions that maximize profit and tenant satisfaction, you're more likely to meet the requirements.
Usually, the 750-hour requirement applies to each real estate property, but you can combine your management activities from multiple properties into one for tax purposes 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.
In the end, REPS can be a powerful tool for high-income earning families to reduce their tax liabilities. It's about optimizing your financial strategy and leveraging real estate investments to your advantage. So, if you're making all the right moves in terms of earning, donating, contributing to retirement, and investing in real estate, don't pay more in taxes than you should – let REPS help you keep more of your hard-earned money in your pocket.