Do you have a rental property or are you looking to invest in one?

In this article we will explain the different tax benefits you can take advantage of, as well as any pitfalls related to your rental property.

We’ll speak about:

• Active Investing
• Passive Investing
• Tax Benefits
• REPS Status for Doctors
• Short-term Rental Tax Advantages

First, it is important to understand the difference between active and passive investing. Read on to determine which one makes the most sense for you.

Active Investing

Active investing in real estate can take several forms, such as Traditional Rentals, Property Flipping, and Wholesaling. In any form, active investing involves your time and money, risk, and requires some understanding of the market to be able to perform well. It is helpful to think of active investing as your main occupation in the eyes of the IRS. This can make it difficult for a doctor or other healthcare professionals to qualify with a full-time position.

For traditional rentals, active investing requires the taxpayer to actively manage the property investment themselves.

Property flipping is a very common active real estate investment. Investors often find an off-market deal, purchase the property at a discount, and then turn around and sell immediately for a profit. This can be lucrative, but it also requires a lot of work as it can be difficult to find the right property. Another type of property flipping is the fix-and-flip. An investor will buy a property that needs work and fix it up with the hopes of selling it for a profit. These investments can be risky and involve a lot of time and money.

Wholesaling is another active real estate investment option. Instead of purchasing a home and selling it, a wholesaler contracts with a seller for the property, finds a party interested in buying it, and sells them their rights to the contract. In this case, you are purchasing and selling contracts rather than physical real estate. Wholesaling is a low-risk strategy, because it requires little money upfront. In order to make reliable income quickly, you will need to have a solid pipeline of leads that can deliver investors to purchase the contracts.

Pros of active real estate investing:

• Flexibility
• More Control
• Tax Benefits
• Cons of active real estate investing:
• More Risk
• More Expenses

Passive Investing

Passive Investing, on the other hand, is a hands-off approach to real estate investing. There are a few different ways to invest in real estate passively, including hiring property managers, real estate investment trusts (REITs), crowdfunding opportunities, remote ownership and real estate funds.

With all these investment types, you can make some extra income without having to be actively involved. With direct rental real estate ownership (also called Remote Ownership), there is low manual labor involved because you have hired a property manager to handle most situations with tenants.

REITs and Real Estate Funds are very similar to investing in a mutual fund. The fund itself will invest in and manage various properties, usually in the commercial space, and pay out any profits as dividends to their shareholders. This is a low-risk investment, and generally one that pension providers will invest in, though the returns are not as significant as some other options.

Crowdfunding is just as it sounds, resources are pooled together with other people (usually facilitated through an online platform), and then invested in mortgage loans around the country. This is similar to any platforms that allow you to buy partial shares of a company’s stocks.

Pros of passive real estate investing:

• Little investment required to start
• No physical labor or landlord duties involved.
• Less capital gains tax in the short term.
• Cons of passive real estate investments:
• Less profitability than active real estate investments.
• Less control over how the asset is managed.

There is always the risk with both active and passive real estate investment that vacancies and/or declining property values could make the investment less profitable.

Tax benefits of active real estate versus passive real estate

In the real estate world, passive investment is the “default” status. Passive investors can only deduct passive losses against passive income in the current year. If you do not use all your passive losses in the current year, they will be carried forward each year until you either have passive income to put against it or sell the property.

Active real estate investors can deduct any losses generated against their ordinary income, therefore having the opportunity to recognize significant tax savings.

How to change a passive real estate property into an active real estate property

Since most physicians are working in a full-time medical role, it is difficult for them to qualify their real estate as an active investment to take advantage of the tax benefits. However, there are two readily available ways to change the way your passive direct ownership real estate is being taxed:Real Estate Professional Status and Short-Term Rentals.

Real Estate Professionals Status (REPS)

REPS is a designation given to anyone who qualifies to claim they work on real estate (and related tasks) as their primary work. The benefit of getting REPS is that you can convert passive losses to ordinary losses. REPS is generally only beneficial if you have real estate losses and any prior year losses you accumulate cannot convert to active in the year you elect REPS.

To become a real estate professional, you must fulfill the following three conditions outlined by the IRS:

1. Perform more than 50% of services in real property trades or businesses (“50% test”), and
2. Perform more than 750 hours of service in real property trades or businesses (“750 hours test”), and
3. Materially participate in each rental activity (“material participation test”).

These tests must be applied every year, meaning your status can change over time.

It can be difficult to meet the conditions required to qualify for REPS when you are physician. However, if you are married and your spouse does not work full-time, your spouse may be able to meet the requirements.

What does it mean to materially participate in real estate activities?

Material participation essentially means that you worked on your real estate activities “on a regular, continuous, and substantial basis during the year.”

The IRS uses seven different tests to determine whether you materially participated. You only need to qualify for one out of the seven. Generally, investors will aim to fulfill either the first test or the third test.

1. Taxpayer works more than 500 hours in the activity. Unlike the 50%- and 750-hours tests, participation of both spouses is counted for material participation. Participation by children or employees is not counted.
2. Taxpayer does substantially all the work in the activity.
3. Taxpayer works more than 100 hours in the activity and no one else works more than the taxpayer (including non-owners or employees).
4. The activity is a significant participation activity (SPA), and the taxpayer’s total time in all SPAs exceeds 500 hours. Rental or leasing activity is not considered an SPA.
5. Taxpayer materially participates in the activity in any five of the prior ten years.
6. Taxpayer materially participates in a personal service activity for any three prior years.
7. Based on all facts and circumstances, taxpayer participates in the activity on a regular, continuous and substantial basis during such year.

What are qualified real estate activities?

Real estate activities can include any of the following outlined by the IRS code:

• Property development and redevelopment
• Construction and reconstruction
• Acquisition and conversion of properties
• Property rentals and management
• Operations
• Leasing or brokerage trade or business

You can prove your REPS by keeping track of your activities via an Excel or Google Sheet timesheet with dates, descriptions and times.

Also, it can be easier to qualify for REPS if you aggregate all your properties into one single activity, which can be done by your accountant. However, keep in mind that if a property generates net income, the income will be deemed as nonpassive and taxed as ordinary income. It is best to speak to a tax advisor to determine which path is best for you.

Short-term rental tax advantages

REPS can be a great option, but not everybody can attain this due to not having a spouse that will or can qualify. A great alternative is short-term rentals.

The IRS short term rental tax guidance outlines six ways in which income from a rental property can be excluded from the definition of passive income.

1. The average stay of each customer is less than 7 days.
2. The average stay of each customer is less than 30 days and significant personal services are provided by (or on behalf of) the owner of the property. This could be anything from daily cleaning to meals.
3. Extraordinary personal services are provided in connection with making the property available for use by customers.
4. The rental is treated as incidental to a non-rental activity, for example providing tours of your farmland or horse riding, etc.
5. You often make the property available during defined business owners for nonexclusive use by various customers.
6. The provision of the property for use in an activity conducted by a partnership, S corporation, or joint venture in which the taxpayer owns an interest is not a rental activity.

Creating Additional Deductions for your Rental Real Estate

Bonus Depreciation

Bonus depreciation is essentially a version of accelerated depreciation. It allows you to take assets that have a 5-15 year asset life (like improvements to a house) and expense all of the depreciation in one year instead of spreading it out.

Cost Segregation Studies

Cost segregation is a study performed by specialized groups. They will evaluate the different components of the house and building and assign a different tax “life” to the asset. Different parts of your house will therefore have a different tax life and will be depreciated over the lower life of those assets. Assets generally adhere to the following rules:

5-year life span - examples: carpets, appliances

7-year life span - examples: office furniture

15-year life span - examples: fencing, land improvements.

27.5-year life span - examples: anything structural.

So, when adding bonus depreciation and cost segregation together, you can create large paper losses without losing money from the bank. These losses can then offset taxes on other sources of income as well when you qualify as active rental real estate.

To conclude, the type of investment you participate in will depend on how much time you have available to dedicate to the investment, available funds, and current life goals. As always with these things, it’s important to have a good tax advisor to guide you and ensure that you are making the right decision.

Alexis E. Gallati, EA, MBA, MS Tax, CTS, is the founder and Lead Tax Strategist at Cerebral Tax Advisors, and the author of the book “Advanced Tax Planning for Medical Professionals”. Not only does she have extensive experience in high-level tax planning strategies and multi-state tax preparation, but she also holds two master's degrees, and serves as an Enrolled Agent, NTPI Fellow, and Certified Tax Strategist. Alexis grew up in a family of physicians and is married to a private practice physician. Physicians and healthcare professionals all over the country work with Cerebral Tax Advisors to lower their personal and business taxes through court-tested and IRS approved tax strategies.