CARL WATTS & ASSOCIATES

March 30, 2015

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Real Estate Pro
vs. Real Estate Investor
Arguably, there is little difference between the two terms in most dictionaries and they are often used interchangeably.

There is quite a different matter when it comes to taxes and what the IRS definitions for the two terms are.

Now, if you invest in real estate and have profits from your investment, good job, you just have to pay taxes on your income, be it active or passive, like everybody else; if you have real estate investment losses, here is where our little story begins.

Ever since the Tax Reform Act of 1986, real estate investments are considered passive investments, which is typically a buy-and-hold form of investment with the intention of long-term appreciation and limited maintenance. Consequently, there is a passive activity loss rule stating that losses from any real estate activity are per se passive and cannot be offset against income from non-passive activities.

The passive activity rules were intended to discourage tax-shelter investments, and also cover real estate investors and persons who invest in businesses as “silent partners” or who are not involved full time in the business. Therefore, from the IRS point of view, there are two kinds of passive activities: rentals that include both equipment and rental real estate (regardless of the level of participation), and businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis.

The IRS also specifies that an activity is a rental activity if tangible property (real or personal) is used by customers or held for use by customers, and the gross income from that activity represents amounts paid mainly for the use of the property.

But most importantly, the IRS states that a rental activity is a passive activity even if you materially participated in that activity, unless you materially participated as a real estate professional.

So who is a real estate professional in the eyes of the IRS and why is it important?

It is important because the Revenue Reconciliation Act of 1993 allowed a taxpayer who met the requirements necessary to be considered a real estate professional to bypass the passive activity rules for real estate investments and apply unlimited losses from their real estate activities against any other earned income.

To qualify as a real estate professional you must meet both of the following requirements:

  1. More than half of 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; and

  2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

To be considered a real property trade or business, your trade or business must develop or redevelop real property; construct or reconstruct it; acquire it; convert it; rent or lease it; operate or manage it; or broker it.


Personal services performed as an employee in real property trades or businesses do not count unless you owned more than 5% of your employer's outstanding stock, outstanding voting stock, or capital or profits interest.


To determine if you materially participated in a trade or business activity you must satisfy any of no more and no less than seven tests. Here are just three of the tests:


  • You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years;
  • You participated in the activity for more than 500 hours;

  • Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the respective year.

If a married couple files a joint return, the two spouses will qualify as real estate professionals only if one of them separately satisfies the two statutory tests. Married taxpayers filing separately must establish that he or she separately meets both statutory tests to qualify as a real estate professional.

If you are not a real estate professional but are an ordinary real estate investor with a number of rental real estate properties in addition to your regular business, than you are subject to the passive activity loss rule and cannot deduct losses from passive activities against non-passive activity income (such as a salary or income from your business, etc.)

Just to be clear, your passive activity loss for the tax year is the excess of your passive activity deductions over your passive activity gross income.

However, there is one important exception to this rule which allows you to deduct a maximum special allowance of up to $25,000 ($12,500 if you are married filing separate returns and living apart at all times during the year) of loss from your passive activities from your non-passive income, as long as you actively participated in those activities.

Make sure to differentiate active participation from material participation. Active participation can be considered to be the mere fact of making management decisions such as approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.

You can use any reasonable method to prove your participation in the passive activity. For instance, you may show services performed and the approximate number of hours spent by using an appointment book, or calendar.

The maximum special allowance of $25,000 is reduced by 50% of the amount of your MAGI that is more than $100,000 ($50,000 if you are married filing separately). If your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), you generally cannot use the special allowance.

There is no phaseout of the $25,000 special allowance for low-income housing credits or for the CRD.

Of course, you need not worry about passive activity loss limitations if your real estate investments are profitable; you may, at best, worry about the additional net investment income tax, which applies to income from rentals as well.

Profitable or not so profitable, a real estate investor or real estate professional, you will certainly know your best options if you enroll help from a tax professional or financial consultant.
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