Full-Time vs Part-Time InvestingFeb 18, 2021
What are the main advantages of investing in cash-flowing properties?
A lot of people go by the acronym I.D.E.A.L.
When an investor purchases an investment property they can get income, depreciation, equity, appreciation, and leverage. Each of those has different components that could be broken down and analyzed independently.
The one we're going to focus on today is depreciation. This is a subject that means something a little bit different for a lot of investors. We highly recommend you to talk to your CPA about this. If your CPA doesn't have clients that are real estate professionals, it's time for a new CPA.
All we want to do here is give a quick highlight as to what we're talking about when we discuss depreciation. Anytime you take depreciation on real property, the IRS lets you take it over 27.5 years on the sticks and bricks (the vertical improvements of the property).
So in theory, if you had $100,000 of sticks and bricks, and divide by 27.5, you're left with the annual write-off that you get. What's left is the depreciation that you get to claim. And this number is great because you didn't spend the money to get it. It's a passive loss. Right? Well, that only goes so far for most people...
The IRS makes you start to phase that out the more money you make. I think it's somewhere above $100,000, where now if you can't take that deduction every year it stacks up. You can take it in the future. I've heard CPAs call this is your passive losses bucket, meaning losses that have been accumulating that one day you can take. For example, when you sell the property to wash away some of the capital gains or something like that.
Here's the main takeaway that we want to address today. Something we call the holy grail of real estate investing. The idea that you can take those losses from passive to active.
Becoming a "Real Estate Professional"
As a cash-flowing real estate investor, there are criteria you can pass to become a real estate professional. To get that classification on your taxes, you spend a certain amount of time investing, and do a variety of other activities where you can legitimately claim that this is "how I earn a living".
When you do this, the cap that they put on you is lifted and you can have unlimited active losses in your business. So now if you have a lot of rental properties, and you've lifted the cap on losses, you can really give your taxes a kick in the pants (in a good way) and lower them because you've got a lot of depreciation coming your way.
That's a really simplified version of the real estate professional status—you're going from passive to active. Where it really gets cool is with a married couple. This is something we see a lot. While one spouse is earning W-2 wages, the other who maybe isn't working can claim real estate professional status. If this is something you're thinking about doing as well, we'll remind you that it's up to you and your CPA to discuss whether it's appropriate or not.
One spouse claiming real estate professional status can do some serious damage to the amount of taxes owed by the full-time spouse. And once again, we mean damaged in a good way. They've got all those passive losses applied against the income taxes for the active working W-2 earning spouse.
The full-time real estate professional classification is a pretty useful classification. It can get even juicier if you can front-load some of that depreciation through cost segregation studies and some energy efficiency studies. That's something we can talk about another time...
If you are a real estate investor and want to be classified as a real estate professional, there are a lot of CPAs out there that specialize in this. An example of someone we refer a lot of clients to is Kohler & Eyre, CPAs. They've done a good job for us and we'd be happy to put you in touch.
Qualifications for becoming a real estate professional
You have to have some properties. You can't say you make a living doing this, and you only own 1-2 properties. In general, once you have a few more properties and can show there's some legitimate income coming in, that's a good place to start.
Another qualification is that you have to spend 750 hours a year doing material participation. We've heard so many definitions as to what material participation means. Some keep a log of every time they've talked to the property manager, among other things. Others say if you have a property manager, you can't be a real estate professional because you've outsourced it. Figure this out with your CPA. Depending on the time spent and activities that you're doing, you can make the case that you are a real estate professional.
Do you need a real estate license?
You do not. One can absolutely earn a living in real estate without being a licensee. Just because you own a bunch of properties doesn't mean you have a license. However, most people seem to think it doesn't really hurt to get one if you're planning on being this involved. That's up to you to weigh the pros and cons. Ultimately, as we've said before, this is a conversation you want to have with your CPA. Some CPAs are extremely cautious and say you'll get killed in an audit unless you stick to the letter of the law, while some are willing to take a chance.
The reality is, it's possible for you to get to the point where it's clear that you definitely and legitimately are a real estate professional. And if you do, we don't know if there's a better tax advantage than that.