Owning real estate is an excellent way for physicians to earn passive income. This passive income is also highly tax-advantaged, meaning there are several ways to offset the taxes you’d otherwise pay on this income.
Depreciation is one such example. In short, depreciation is a deduction that owners can take over several years. For residential properties, depreciation is taken over a 27.5-year period, which the IRS considers the “useful life” of a residential building. For example, a rental building with a cost basis of $250,000, where the land is worth $100,000, would generate depreciation of $5,455 per year ($150,000 / 27.5 years) which can then be used to offset your taxable income. A taxpayer can write-off depreciation even if a property is profitable and appreciating in value.
There are other nuances to how rental real estate income is taxed—nuances that are not as well understood by average investors.
In this article, we take a deep dive into how real estate income is taxed. As you’ll see, there’s a special tax benefit to becoming a designated “real estate professional” in the eyes of the IRS. We’ll take a look at the benefits this designation carries and how you might be able to qualify.
An Overview of How the IRS Taxes Real Estate Income
First, let’s learn about how the tax code views real estate income. Let’s assume, for now, that you are not a “Real Estate Professional” according to IRS rules. You are a physician who spends their 8-to-5 (and well beyond) in a clinic or hospital, tending to your real estate properties on an as-needed basis. This makes you a passive real estate investor, as is the case with most who buy real estate as an investment.
Passive real estate investors should expect to be taxed as follows:
- Taxed as Ordinary Income: Any income generated by a rental profit is considered “ordinary income,” meaning you will be taxed according to your tax bracket. Physicians and other high-income-earning professionals tend to fall into higher tax brackets, and can, therefore, expect to pay upwards of 38% taxes on net income generated by their rental portfolio.
- Net Investment Income Tax: This is an additional 3.8% tax that applies to anyone whose adjusted gross income for the year exceeds $200,000 (or $250,000 for those who are married and filing jointly). The 3.8% tax is on all passive investment income (not just real estate), which includes rental income.
As noted above, there are several write-offs, like depreciation, which can lower your tax burden. Deductible expenses include but are not limited to: advertising, cleaning and maintenance, commissions, depreciation, homeowners’ association dues or condo fees, insurance premiums, interest expenses, landscaping, local property taxes, management fees, pest control, repairs and maintenance, snow removal, supplies, trash removal fees, travel, and utilities.
Anything you deduct must be “ordinary and necessary,” according to the IRS. For example, travel must be directly related to the property. If you’re mixing business with pleasure, you must allocate the travel costs between deductible business expenses and nondeductible personal costs. Excellent record-keeping is the best way to protect yourself in the event of an audit.
Now, anyone who is a passive real estate investor is limited to taking $25,000 in write-offs each year. In theory, even a profitable rental real estate can, therefore, generate “paper losses,” which can then be used to offset other passive income – such as dividends earned on a stock portfolio. If you have more passive losses than passive income in a given year, you can “suspend” those passive losses and roll them forward to the next tax year.
There’s another designation, called an “Active Investor,” which increases the deduction threshold from $25,000 to $50,000 for those who qualify. It is relatively easy to qualify as an Active Investor. You must simply be involved in the decision-making for the real estate. For example, if you’re a limited (silent) partner that’s invested in a real estate fund, you’re most certainly a passive investor. If you’re a physician who has personally and exclusively invested in two or three rental properties, you are an active investor per the IRS. There is no burden of proof needed to show the IRS that you are an active investor, making this designation supremely easy for those who otherwise qualify.
Of course, this benefit doesn’t last forever. Regardless of whether you’re a passive or active investor, your ability to take these deductions begins to phase out once you earn more than $100,000 in adjusted gross income. A single person who earns more than $150,000 in adjusted gross income cannot claim any write-offs against their passive income. Which means many physicians cannot benefit from being in “Active Investor.”
Rental Income is Taxed Differently if You’re a “Real Estate Professional”
In addition to Passive and Active Investors, the IRS has a third designation for “Real Estate Professionals.” Rental income is taxed much differently when you’re a Real Estate Professional.
Let us elaborate.
Anyone who is a Real Estate Professional per IRS rules can write off 100% of their real estate losses (real or paper) against their ordinary income (not just passive income, as is the case with the other classifications). There is no cap on the value of the deductions you take. Therefore, Real Estate Professionals, particularly those with large rental portfolios, can actually offset their entire income (active and passive) via deductions – thereby resulting in zero tax liability at the end of each year.
Even if you can’t offset all of your income, you can certainly offset a large chunk of it by utilizing the Real Estate Professional designation.
For example, let’s say you make $300,000 a year as a nephrologist. Your rental portfolio generates $50,000 in losses each year via depreciation, expenses and other deductions. Your spouse takes over the lion’s share of managing your real estate portfolio and therefore, is eligible for Real Estate Professional status when you file your taxes. The $50,000 can then be used to offset your income as a nephrologist, thereby reducing your modified adjusted gross income to $250,000. This should save you nearly $14,000 in taxes that year!
How to Achieve IRS Real Estate Professional Status
The IRS has detailed rules outlining what is required to earn the real estate professional status. It’s actually more difficult to achieve than one might expect. The IRS uses a two-step process – investors must meet both criteria to qualify:
- The Quantitative Test
A person must spend at least 750 hours per year managing their rental portfolio. This must be their primary occupation. In other words, you must spend more hours managing your rental portfolio than you do on any other occupation. So, if you’re a physician who spends 1,500 hours per year in a clinical setting but also spend 750 hours managing your real estate, you would not qualify as a Real Estate Professional. You would have to work 750+ hours in real estate and spend fewer hours as a physician.
What qualifies? Activities that count toward that 750-hour threshold include: overseeing repairs or renovations to a property, personally engaging in construction activities, marketing a property, and showing and/or leasing your rentals. Hours that do not count include investment activities, such as researching new opportunities, and time spent “on call” for tenants. Travel time is sometimes eligible toward the 750-hour minimum, but IRS rulings have varied – so those wishing to be conservative may not want to include this time in their overarching calculation.
Technically, the IRS is looking for you to spend 750 hours on each rental property. However, the IRS does allow you to group properties by making an election to treat all of those interests as a single activity. By doing so, you must only spend 750 hours across your entire rental portfolio.
As a final caveat, the IRS requires you to have at least 5% ownership stake in each of the rental properties for which you are claiming to be a Real Estate Professional.
In sum, remember this formula: 750-hours + 50% or more of your time + 5% ownership stake.
- The Material Participation Test
In order to earn Real Estate Professional status, you must “materially participate” in your real estate investments (though your time can be aggregated for this, as noted above). According to the IRS, the following activities qualify toward material participation:
“Real property development, redevelopment, construction, re-construction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
You must do these tasks, all or in part, on a regular, continuous and “substantial” basis to be considered a Real Estate Professional. The IRS uses a 500-hour threshold to determine material participation across industry classifications, which is an easy burden to achieve for those in the real estate industry as the Real Estate Professional designation has a 750-hour minimum requirement already.
An important clarification to make: material participation does not require you to manage the properties day-to-day. In fact, you can have a property manager and still qualify. Moreover, you do not need to have a real estate license to qualify.
We mentioned above that hours spent on investment activities do not count toward the Quantitative Test. And while that’s true, hours spent as an investor (e.g., studying and reviewing financial statements, preparing summaries of the finances or operations, or managing the finances) CAN be counted toward the Material Participation Test – if you are directly involved in the day-to-day management of the portfolio. Otherwise, these activities are ineligible.
A few other points of note:
- As noted above, investing in a syndication as a limited partner does NOT for the purpose of either the Quantitative Test or the Material Participation Test.
- You and your spouse CANNOT pool your hours spent on your rental portfolio to achieve the 750-hour minimum threshold. One of you must be able to pass both tests individually.
- A corporation (such as an LLC) may qualify as a Real Estate Professional if more than 50% of the gross receipts for the business are from real estate.
Documentation Required to Become a Real Estate Professional
There are real benefits to earning Real Estate Professional status, but it is a designation that physicians can struggle to achieve. The Internal Revenue Service takes this designation seriously and will audit those who seem unlikely to meet the threshold. In other words, if you’re a high-earning physician, the IRS will find it suspect that you also spend more than 50% of your time overseeing your real estate portfolio.
Taxpayers who are considering filing as a Real Estate Professional will want to keep detailed records in the event of an audit.
The IRS says you can prove your Real Estate Professional status through any “reasonable means,” which the IRS does not actually specify. Consider tracking your real estate activities as follows:
- Use a separate email account for all real estate activities. This will make it easier to find and track emails if needed for an audit.
- Log all calls as they occur. In your log, jot down notes to describe the purpose of the call.
- Use a separate calendar to track all meetings, events, site visits, etc. related to your rental portfolio. Again, make detailed notes about each of these appointments to use as backup if needed.
- Open a bank account that is exclusively used for your real estate. Similarly, have a separate credit card that is only used for real estate expenses. You want to be sure not to co-mingle funds (personal and those related to your portfolio).
- Utilize accounting software (or better yet, hire an accountant) to track all of your income and expenses in real time.
Remember: If the IRS challenges your position on an audit, then the burden of proving you qualify falls squarely on your shoulders. The taxpayer must be able to demonstrate they played by the rules and meet the IRS guidelines.
Strategies for Becoming a Real Estate Professional
We’ve alluded to this already, but it’s important to reiterate: becoming a Real Estate Professional is no easy task for actively practicing physicians. But that’s not to say it can’t be achieved, particularly for married couples where one spouse does not work outside the home, or works part-time AND is willing to take on the management of all the real estate holdings.
Here are a few strategies for becoming a Real Estate Professional:
- If you are already employed full-time, have your spouse pursue the designation. Of course, your spouse actually has to perform the work – not just say they’ll do the work. Be sure your spouse is on board with this strategy. You’ll want to closely review the criteria and ensure your spouse is interested in taking on this time-consuming role.
- If you work part-time (or could work part-time), evaluate the number of hours you spend working as a physician and determine whether you’d be able to spend > 50% of your remaining time managing your real estate portfolio.
- If you’re a retired physician, take on more of the day-to-day management of your real estate portfolio. You may find that you’re already spending 500+ hours on your rental properties each year, in which case increasing your time spent could quickly put you over the threshold needed to qualify.
Pulling It All Together
There’s no right or wrong decision when evaluating whether to become a Real Estate Professional. It’s certainly not the right move for everyone, especially for already high-income-earning physicians who are better off focusing on their practice instead of their real estate portfolio. That said, it’s an important designation to at least be aware of. Perhaps this isn’t the right season of your life to pursue the status. Maybe it isn’t something you’d want to consider until much further down the road. In any event, understanding how your rental income is taxed – and how to potentially reduce that tax burden – is important for anyone interested in maximizing their rental income.
Have any lingering questions? Let me know! Find me at firstname.lastname@example.org.