REPS (Real Estate Professional Status)

A taxpayer qualifies as a real estate professional for any year the taxpayer meets both of the following requirements:

 

(1) more than half of the personal services performed in all trades or businesses during the tax year were performed in real property trades or businesses in which the taxpayer materially participated; and

 

(2) the taxpayer performed more than 750 hours of services during the tax year in real property trades or businesses in which he or she materially participated (Sec. 469(c)(7)(B)).

 

Material participation refers to a classification the IRS uses that focuses on the taxpayer's level of participation in their business, rental, or income-producing activity. An activity is a single economic unit used to measure gains or losses. If your income-producing activity rises to the level of material participation, then the income you generate will be characterized as active income (i.e., non-passive income) and you can use any losses incurred to offset other categories of income. Additionally, as a taxpayer, you will not be subject to the Net Investment Tax.

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The IRS has set out seven tests to meet the material participation standard. 

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Material participation test (1/7 TESTS BELOW TO QUALIFY ANNUALLY)

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1 You participated in the activity more than 500 hours during the tax year (most utilized test). Note that if you are married and file a joint return, the hours your spouse spends participating in the business activity count toward the 500-hour requirement for material participation. This is great news for taxpayers who have a spouse who is also engaged in the same income-producing activity.

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2 Your participation in the activity constitutes substantially all the participation in the business, trade, or income-producing activity (i.e., you performed most of the work).

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3 Your participation in the activities during the tax year exceeds 100 hours and you did not perform fewer hours than any other individual who participates in the activity (this rule does not apply to rental activities).

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4 Your participation in the activity is significant, and the total value of all the significant activities that you participated in exceeds 500 hours. This is known as a significant participation activity.

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5 You materially participated in the activity during any five of the 10 tax years before the current tax year.

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6 If your income-producing activity is a personal-service activity, you materially participated if that activity occurred during the three years before the current tax year. (These years do not need to be consecutive.)

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7 If you participated in the activity for more than 100 hours during the tax year and you can demonstrate based on the facts and circumstances that your activity was regular, continuous, and substantial during the tax year, then the IRS will construe you as a material participant.
 
If you meet one of the seven tests for material participation, as a taxpayer you're in luck this tax season! The income generated will be characterized as active, and you will not be subject to the passive activity loss rules. While this is great news, you should note that you will have to meet the material participation test annually. For future years, you will have to meet one of the seven tests if you want to claim material participation for the tax year.

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Short Term Rentals

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Unlike traditional long-term rental properties that are considered passive activities by default, short-term rental properties are not considered rental activities if one of the following tests are met:

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• The average period of customer use for such property is seven days or less;

• The average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers

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This means that if you have losses from a short-term rental business, and materially participate in the activity, you can use those losses to offset non-passive income (e.g. salary from a W-2 job) without qualifying as a real estate professional.

To demonstrate material participation in an activity you must meet one of the same seven tests described in the real estate professional section above.​

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The good news is, unlike the REPS, the time each spouse spends on short-term rentals will be combined to meet the material participation tests.

 

In addition, you do not have to spend 750 hours and more than half your total time to make this work.

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Considerations Renting Your Primary Residence or Vacation Home

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14 Days or Less

If you rent out your primary residence or vacation home for 14 days days or less throughout the year you do not have to pay taxes on the income. Because your income isn’t taxable, you also can’t deduct your expenses.

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15 Days or More

If you rent your primary residence or vacation home for more than 15 days, then you must report your income on Schedule E of your tax return. However, your expenses are only deductible to the extent of your income. Any remaining expenses will be carried forward to offset income from this activity in future years.

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