The Final Two Tests to Take Real Estate Professional Status on Your Return
In the last blog, we talked about why a Real Estate Professional status can save you tax money. We also talked about the first of three tests you must pass in order to take this designation. Today, we continue on with the final two tests.
This is the second step of REP and it’s the one people are most likely to get wrong. It doesn’t matter if you meet all the hours for real estate professional hands down. If you don’t meet this second step, material participation, you don’t have a deduction.
There are 7 ways to meet material participation:
- 500 Hour Test
- Substantially All Participation test
- 100 Hours + Participation Test
- Significant Participation Test
- Long-Standing Material Participation Test
- Personal Service Activity Test
- Facts & Circumstances Test
The 500 hour test is the most common. With this test, you and/or your spouse prove you have 500 hours of real estate activity related to the property. The IRS really focuses on the term “activity.” They don’t count time you go to seminars or surf the Internet looking for deals. They want to know that you are actively involved in the business. If the property is out of town, make sure you keep proof that you’ve traveled to inspect the property. The IRS is especially targeting real estate owners who use property managers in this case. Their standard belief is that you can’t get 500 hours of activity per property if you have a property manager. Be prepared to show you’ve spent the hours if you’re relying on this 1st step.
The substantially all test says that you have spent substantially all of the necessary time. In other words, you and your spouse have spent more hours than everybody else combined. So, if you have employees or subcontractors who have helped on the property, you’re going to have to prove that you’ve got more hours than everybody else combined. This is a test that a typical do-it-yourselfer would pass. If you’ve got a property manager, though, the IRS is going to consider it pretty much impossible for you to pass.
The 100 hour plus participation says that you meet at least 100 hours in real estate activities related to this property each year and spend more hours than any other one does. The difference between this test and the substantially all test is that with this one you only need to be the one who has the most hours. You don’t need more hours any everyone combined, as you do with the other one.
The significant participation test is a little more obscure. You have to prove that you have significant participation. Personally, I am concerned about trying to pass this objective test and use one of the others.
The long standing material participation test means that you have to show you had material participation during five of the previous ten years. That means you for those previous years you had to have met one of the other tests for material participations. Of course, in order to prove that, you’re going to have to open up those years for audit. In general, that’s probably a bad idea.
The sixth test is a personal service activity test. This is more applicable to a professional business and not to a real estate professional. The seven material participation tests are used for more than just real estate professional status.
The final test is the facts & circumstances test. Under this test, you need to answer ‘yes’ to each of the following:
- Does your involvement relate to the operation of the business as opposed to just the investment aspects?
- Are your contributions significant and more than a mere approval of major decisions?
- Is this activity your principal trade or business?
Each Alone Must Qualify
Each property must qualify alone. That is, unless you decide to make an aggregation election. But there, can be a problem with the aggregation election if you ever sell a property at a loss. Make sure you’ve got some expert advice helping you with this election before you take it!