As a real estate portfolio grows, tax planning tends to become more complicated along with it. One rental may eventually become several properties held through separate LLCs, partnerships, or other entities. Add property managers, acquisitions, renovations, and depreciation strategies, and the tax impact can become much less straightforward.
Real estate professional status, often referred to as REPS, can be an important part of that picture. Qualifying for REPS can change how certain rental real estate losses are treated for tax purposes, but it does not automatically mean every loss from every property can be used to reduce your taxable income.
For owners with multiple properties or entities, how much time you spend in the business, how you participate in each property, and how your rental activities are treated for tax purposes all matter. For that reason, REPS is most useful when considered as part of the broader tax strategy for your real estate portfolio.
What does real estate professional status change?
Rental real estate is generally treated as a passive activity for federal tax purposes. In simple terms, that means losses from a rental property usually cannot be used to offset wages or income from a business in which you actively participate.
That can become particularly important when a property generates a significant tax loss through depreciation. As we discussed in Why Passive Loss Rules Can Limit Your Real Estate Tax Savings, having a large deduction does not necessarily mean you receive the full tax benefit from it right away. If the passive loss rules apply, some or all of the loss may instead be carried forward to a future year.
Real estate professional status can change that treatment. If you qualify for REPS and meet the material participation requirements for your rental activity, losses from that activity may be treated as nonpassive. This can allow them to offset other types of income, subject to other tax limitations.
Therefore, there are two pieces to consider: whether you qualify as a real estate professional and whether you participate enough in the rental activity for the losses to receive nonpassive treatment.
How do you qualify for REPS?
To qualify for real estate professional status for a particular tax year, you generally must meet two requirements:
You spend more than 750 hours during the year working in real property trades or businesses in which you materially participate.
More than half of the personal services you perform in all trades or businesses during the year are in those qualifying real estate activities.
Qualifying activities can include work involving real estate development, construction, acquisition, rental, property management, leasing, and operations, among other activities. The requirements are applied each year, so qualifying for REPS this year does not automatically mean you will qualify next year if your role or the amount of time you spend in the business changes. There are also additional rules that can affect the calculation. For example, services performed as an employee generally do not count unless you own more than 5% of the employer.
Married couples should also pay particular attention to the requirements. One spouse must independently meet the tests to qualify for REPS. You cannot combine both spouses’ hours to reach 750 hours or satisfy the more-than-half requirement. Once one spouse qualifies, however, both spouses’ participation may be relevant when determining whether they materially participated in a rental activity. This is a great tax planning opportunity, and can result in fantastic tax strategies.
Why do multiple properties make REPS more complicated?
For someone who owns one rental property, the participation analysis may be relatively straightforward. It becomes more complicated when the portfolio includes several properties, particularly when they are held through different LLCs or partnerships.
REPS itself generally applies at the individual taxpayer level, so you do not qualify separately for each LLC. However, qualifying for REPS is only the first step; you also need to show enough participation in the rental activity for its income or loss to be treated as nonpassive.
By default, each rental real estate interest is generally considered separately when determining material participation. For example, imagine you spend significant time managing five rental properties during the year. Your total hours may be enough to qualify for REPS, but if each property is treated as a separate activity, you may still need to establish that you materially participated in each one.
Federal tax rules include seven material participation tests in total, meaning there are many ways to meet the standard, and need to meet just one.
The table below focuses on the tests most likely to apply to rental real estate activities:
Material Participation Test | What it means | Why it matters |
|---|---|---|
More than 500 hours | You spend more than 500 hours during the year on the activity | This can be easier to show for one property than for several properties treated separately. |
Substantially all participation | You do nearly all the work on the activity yourself. | This may be harder to meet if you use property managers, employees, or contractors. |
More than 100 hours and no one does more | You spend more than 100 hours on the activity, and no one else spends more time on it than you do. | This often becomes a key issue when outside managers or team members are heavily involved. |
REPS can get more complicated as a portfolio grows. The important takeaway here is that qualifying for REPS based on your overall real estate work does not automatically establish material participation in every property you own. That distinction becomes even more important as a portfolio expands.
Should you group your rental properties?
Real estate professionals may have another planning option: electing to treat multiple rental real estate interests as one activity when determining material participation. This is commonly referred to as a grouping election.
For someone with several rental properties, grouping can make it easier to demonstrate material participation because time spent across the portfolio can be considered together rather than measuring participation property by property. An owner may not spend enough time on any individual building to meet a material participation test on its own but may spend substantial time managing the real estate investments as a whole.
Grouping can help in that situation, but it also has longer-term consequences. Once the election is made, it generally continues into future years. It can also affect the tax treatment of suspended passive losses when individual properties are sold.
If all of your rentals have been grouped into one activity, selling one property generally does not mean you have disposed of the entire activity. As a result, passive losses associated with the broader activity may not automatically become available just because one property was sold.
For owners who regularly buy and sell properties, expect to restructure ownership, or are still building their portfolio, grouping should be considered in the context of those longer-term plans.
Keep track of the work you are actually doing.
Because the REPS rules depend heavily on your participation, documentation is an important part of the planning process. The IRS does not require a specific daily time sheet. Taxpayers can generally use reasonable records such as calendars, appointment books, or other documentation that shows the work performed and the approximate time spent.
It will be more difficult to recreate that information after the year is over. For an owner with several entities or properties, it can be helpful to track:
- which property or entity you worked on;
- what you did;
- approximately how much time you spent;
- whether you or someone else was primarily responsible for managing the property; and
- changes during the year, such as acquiring a new property or hiring a property manager.
Not every hour related to an investment necessarily counts. For example, time spent reviewing financial statements or monitoring an investment strictly as an investor generally does not qualify in the same way as time spent directly operating or managing the property.
That distinction may become more important as a portfolio grows and the owner begins delegating more day-to-day responsibilities to employees or third-party property managers.
REPS is not the only rule that can limit a loss.
Qualifying for REPS and materially participating can make a significant difference in how rental real estate losses are treated. It does not guarantee that every loss will be fully deductible in the current year.
Other rules may still limit the amount you can deduct, including tax basis, at-risk limitations, and the excess business loss rules. Losses that were suspended in earlier years can also require additional analysis.
This becomes especially important when REPS is combined with depreciation planning. A cost segregation study may allow you to accelerate depreciation on certain components of a building, which can create a much larger deduction in the earlier years of ownership.
Whether that deduction provides an immediate tax benefit depends in part on how your rental activity is treated. An owner who qualifies for REPS and materially participates may be able to use those losses differently than an owner whose rental losses remain passive. That makes it important to consider cost segregation, passive loss rules, and REPS together rather than as separate tax strategies.
Are REPS rules different in Wisconsin?
Wisconsin generally follows the federal rules for passive activities and real estate professional status. There is not a separate Wisconsin REPS test requiring a different number of hours or a different level of participation.
However, the amount of a real estate loss recognized for Wisconsin tax purposes can differ from the federal amount. One common reason is depreciation.
Wisconsin does not generally follow federal bonus depreciation rules. As a result, a property may have one depreciation calculation for federal purposes and another for Wisconsin. Taxpayers may need to adjust their Wisconsin return and maintain separate depreciation records. The Wisconsin benefit is less than the federal benefit in the first year, but generally has better benefits in future years due to bonus depreciation rules.
Those differences can also affect passive activity loss calculations. In some situations, Form 8582, which is used to calculate passive activity loss limitations federally, may need to be recomputed using Wisconsin amounts.
This is particularly relevant for owners using strategies such as cost segregation, where depreciation deductions can be significant. Even if the overall REPS rules are the same, the timing and amount of the resulting tax benefit may look different on the federal and Wisconsin returns.
Make REPS part of your real estate tax planning
For owners with a growing portfolio, REPS is worth discussing before the tax return is being prepared. Depending on your situation, that conversation may include questions such as:
- Are you likely to meet the REPS requirements this year?
- How much time are you spending on each property or activity?
- Are your rental properties currently treated separately or as one activity?
- Has a grouping election already been made?
- Are property managers or other employees taking over more of the day-to-day work?
- Do you have passive losses carried forward from earlier years?
- Are you considering a cost segregation study?
- Are you planning to buy, sell, or restructure any properties?
These questions become more important as ownership spreads across multiple properties and entities. The way you participate in the business, structure your activities, and plan for future transactions can all influence how much of your real estate tax deductions you are able to use and when.
Before buying, renovating, restructuring, or selling real estate, talk with a Wegner tax advisor about how REPS and other real estate tax strategies may work across your entities.
