Are You an Active or Passive Investor?
There are many ways to get into real estate and start earning money as an investor. Income from “wholesaling” and “fix and flip” are considered active earned income and taxed at a higher rate (think W-2, 1099, etc).

If your investing strategy is “buy and hold” for longer than a year or money lending, income earned would be considered passive and therefore taxed at a lower rate.
While I am not a CPA or tax attorney, it is very important to understand how taxes will impact your investment.

What is the best strategy to start with?
Everyone is different and what may work for one investor may not be enough for another. Think short term rentals, i.e. AirBnb, for a moment. You find a property in the Smokey Mountains and rent out by the week to vacationers. You realize your monthly cash flow is sometimes 4x much more than your “buy and hold” long term rental.

These are two separate asset classes and you are comparing apples to oranges. The short term rental, in the eyes of the IRS, are considered active earned income and taxed accordingly. You are actively managing a hospitality business, and as such, your ROI expectations should be higher. Compared to managing a long term rental, which is considered passive income and taxed at a lower rate.

Single Family versus Multifamily
Many real estate investors start out investing in single family homes, condos, and townhomes because it is much easier to enter this space. You soon realize that landlording can be a bit of a headache and outsource property management to a another firm, only to realize all your profits may be gone.

If you have a day-time job, landlording may sometimes feel like a full time job. You are actively managing your properties, but the IRS tax codes treat you as a passive investor.

On the flip side, investing in a syndicated multifamily asset provides passive income while you maintain your day-time job as a professional, but without the heavy lifting of tenants and toilets.

I personally am an active investor, as a syndicator and operator of short term and long term rentals. The deals that we find in the multifamily space provides an excellent return, so I am also a passive investor. It is important to understand your own tax situation in order to reap the benefits that the IRS tax codes allow. Don’t leave money on the table!

Where you need to understand is the impact of your tax status, am I a real estate professional?

Are you a real estate professional?
If you are a real estate professional and are able to qualify as such on your tax return, this can mean serious tax savings for your savvy investments. Speak to a CPA who thoroughly understands how your real estate investments can impact you in your tax filing.

There are a variety of tax rules for real estate professionals. Three of the most important include:
• Passive loss rules
• Real property trade or business rule
• Material participation rules

Read on for an overview of the key tax rules real estate professionals need to understand in each of these categories.

Passive Loss Rules
According to IRC Section 469, rental real estate is classified as a passive activity. This classification implies that losses incurred from rental real estate, usually resulting from depreciation, can solely offset other passive income, such as rental income.
Investors should take note that losses from their rental real estate portfolio cannot be utilized to offset non-passive income, like earnings from a W-2 job or owning a business. However, the tax advantages of investing in real estate may be take a different form and may be beneficial in other ways. Speak to your CPA about the impact of passive loss carryforwards against gains from other passive investments such has the sale of a long term rental or your portion of the gain on sale of a syndicated multifamily asset.

Real estate professionals, from a tax perspective has a very specific definition. Per the IRS, individuals who operate their real estate business full-time can claim an exception from this treatment by pursuing real estate professional status. Qualifying as a real estate professional alone does not deliver any tax benefits, such as a real estate agent who has a license but does not materially participate.

Individuals must prove they materially participated in a real property trade or business during that tax year. Let’s take a closer look at the rules that govern those tests.

Real Property Trade or Business Rules
To have your losses be treated as non-passive, you must participate in a real property trade or business during the tax year. If you operate your own real estate portfolio, you likely satisfy this requirement. However, it’s worth knowing exactly what the rules and tax court precedent state.

The IRS specifies 11 types of real property trades or businesses. To qualify as a real estate professional, you must perform at least 750 hours of personal services by materially participating in one of these activities (more on material participation in a moment). You should also own at least a 5% equity stake in the real property trade or business.

The 11 categories are real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage.

Material Participation Rules
Another important tax rule real estate professionals need to understand is the concept of material participation. To have rental losses be treated as non-passive, real estate professionals must show that they materially participated in their rental business.
What does that mean? To materially participate, individuals must pass one of seven tests outlined by the IRS. Of the seven tests, the 500-hour participation rule is the one that is most commonly used by real estate professionals.

These hours must be spent on certain activities related to your real estate property. Generally, only activities directly related to your rental real estate count: tasks like processing tenant applications and working on repairs. Time spent on activities like education, research, and travel generally does not count.

You must meticulously track every hour you spent on your rental business and collect documentation that backs this up. In the event that you’re audited, the burden of proof is on you, not the IRS, and having receipts, calendar appointments, and emails that substantiate your position is vital.

Again, all of these points need to be validated with a CPA that has had real estate investment experience themselves or the majority of their clients are real estate investors.

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