Due to the incredible benefits of the VA home loan, many military veterans end up as landlords. And, some of these individuals become full-time real estate investors after their military service. To reduce their tax burdens, these investors often ask about the real estate professional designation for veterans. As such, we’ll use this article to outline this designation and how veterans can potentially use it to save a ton of money on taxes.
Specifically, we’ll discuss the following:
- IRS Income Classifications
- The Tax Advantages of the Real Estate Professional Designation
- How Veterans Can Qualify as Real Estate Professionals
- Final Thoughts
IRS Income Classifications
Prior to discussing the real estate professional designation – and its incredible tax benefits – we need to first outline some IRS income classifications. Depending on how you earn money, the IRS treats that income differently for tax purposes. Broadly speaking, three income categories exist: active (or nonpassive), portfolio, and passive. For the sake of this article, we’ll focus on active and passive income.
This category includes all earned income (e.g. wages, tips, and active business participation). For self-employed individuals, business earnings also qualify as active income. The IRS taxes this income at an individual’s marginal tax rate, currently ranging from 10% to 37%. Additionally, individuals must pay payroll taxes (Social Security and Medicare) on this income. Of note, employees pay half of the payroll tax burden (with the employer paying the other half), while self-employed individuals must pay the entire amount.
With respect to real estate, the IRS defines this as the income earned from rents (i.e. rental property income). And, the IRS taxes this income at an investor’s marginal tax rate – the same as with active income. However, passive income is not subject to either payroll or self-employment tax.
Why It Matters
According to the IRS, passive losses can generally only offset passive income. This has huge consequences for real estate investors. Due to the benefits of property depreciation – a cashless expense – real estate investors often have tax losses despite positive cash flow.
For example, assume a multifamily property generates $50,000 in annual operating income. Ignoring debt service, if the property has an annual depreciation expense of $75,000, investors have a tax loss of $25,000 while still putting $50,000 in their pockets – not bad!
But, due to passive activity loss (PAL) limitations, the IRS says you can’t use that $25,000 loss to offset your active income (e.g. your or your spouse’s salary). In other words, if you don’t have other rental property income, you can’t use that $25,000 loss to reduce your current tax bill (but, you can use it in future years when you do have passive income or sell the associated property).
NOTE: The IRS does allow for an exception to these PAL rules, where investors below a certain income threshold can deduct up to $25,000 in rental property losses against active income. But, for the sake of this article, we’ll assume that investors have incomes above this threshold.
The Tax Advantages of the Real Estate Professional Designation
These limitations on passive losses take many new investors by surprise. People often hear about all the tax advantages of real estate investing and assume they can use any losses to reduce other income. As outlined, this is not the case for most investors, which creates a nasty surprise at tax time for people expecting to take advantage of a rental property’s taxable loss.
However, in some situations, investors can use their rental property losses to offset their active income. If you qualify as a real estate professional – a formal IRS designation – certain passive income becomes nonpassive. That is, qualifying rental income falls into the same category as all of your other active income while not being subject to self-employment taxes. Continuing the above example, assume that you qualify as a real estate professional. Now, you could use that $25,000 loss from your multifamily property to reduce your or your spouse’s taxable salary by $25,000.
And, with larger property portfolios, annual taxable losses can total hundreds of thousands of dollars. For couples or individuals with large salaries, these losses can effectively eliminate the income taxes you need to pay on those salaries. Clearly, becoming a real estate professional has huge tax benefits for investors.
How Veterans Can Qualify as Real Estate Professionals
But, due to these potentially huge tax benefits, the IRS imposes strict criteria to qualify as a real estate professional. Simply having a rental property or working in the real estate industry does not make someone a real estate professional. Rather, the IRS imposes two tests to qualify. More precisely, investors must meet both of the below tests in a tax year to receive real estate professional designation:
- 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 investor] materially participated.
- [The investor] performed more than 750 hours of services during the tax year in real property trades or businesses in which [he or she] materially participated.
Due to these tests, active service members (and people with full-time jobs outside of real estate) generally cannot qualify as real estate professionals. That is, the IRS will find it hard to believe anyone serving on active duty could devote 750 hours on top of their military service in “real property trades or businesses” (e.g. real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business).
But, options do exist for veterans to qualify as real estate professionals and reap the associated tax benefits. In particular, here are two common scenarios veterans use:
Option 1: Spouse Qualifies
Fortunately, the IRS does not require both spouses to qualify as real estate professionals to take advantage of the designation’s tax benefits. For instance, say your spouse works full-time in the real estate industry and qualifies. Assuming you use the married filing jointly tax filing status, your spouse’s status will allow you both to offset active income with eligible rental property losses.
Here’s a typical scenario. A veteran retires from the military, begins another career, and also manages a portfolio of rental properties on the side. At the same time, the veteran’s spouse works in real estate and qualifies as a real estate professional. Due to one spouse having this designation, rental property tax losses can offset the veteran’s salary.
NOTE: The IRS clearly states that investors cannot count personal services performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. As a result, hours simply working for a company in the real estate industry do not count towards the above requirements.
Option 2: Qualify as a Veteran
Alternatively, you as the veteran could qualify as a real estate professional. But, due to the above criteria, you generally would not be able to have another full-time job outside of real estate to do so.
Frequently, veterans with rental property portfolios achieve this tax status by forming a property management company. That is, if you already manage your properties on the side, establish an LLC or other legal entity to formalize the process once you separate from the service. Then, the hours you spend working in that property management capacity will contribute to the real estate professional status requirements.
This situation makes sense for veterans who have spouses with high-paying jobs. Say your spouse makes $200,000/year in salary. Normally, your rental property losses cannot offset this active income. But, if you qualify as a real estate professional, the eligible losses from your rental property portfolio can offset your spouse’s salary, potentially saving you a ton of money.
In this article, we only scratched the surface of the real estate professional designation – and how it can save veterans a lot of money at tax time. But, as with all tax-related items, far more details exist to comply with IRS requirements. As such, we hope this article plants the seed of the potential behind the real estate professional designation. If you’re a veteran with a portfolio of rental properties, a tax professional can help walk you through the detailed steps to qualify for this outstanding tax designation.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.