016: Is Being a Real Estate Professional for You?
Welcome back, Cashflow Multipliers! If you know anything about us by now, it’s that we are all about sharing the knowledge we have gained in apartment investing and passive income. This episode is dedicated to making you financially free. 🤟 Our weapon, or rather, wealth, of choice, is through apartment investing and it can be a wonderful world.
Apartment investors really do get the best of everything. We get monthly or quarterly cash flow, hedge money against inflation, invest in risk-averse asset classes and get above-average returns. The best part? We can beat Uncle Sam at his own game. 👊
Yep, apartment investors get some of the best tax benefits. 😵😵
You’ve probably heard the saying, “it’s not what you can earn, it’s what you can keep.” That’s why those who are high-level entrepreneurs or high-income earners don’t have that many tax advantages available to them, so paying a significant amount in taxes is, unfortunately, the norm.
If you’re sitting there thinking, “wait a second, I thought you two were supposed to make me a high-income earner! What is this?!” Hold on one second. We’re in the business of making you, high-level investors.😘😘 What’s the difference and how do taxes have anything to do with it? That’s where the ESBI quadrant comes in. All of that can be found in episode 11 where we break down:
E for Employee
S for Self-Employed
B for Business Owner and
I for Investor
No, this isn’t an episode of Sesame Street, this is how you legally, ethically, and morally do not pay taxes. And that, you guessed it, is through apartment investing.
Passive Income vs. Active Income
So let’s break down the definitions of passive income vs. active income. Our good ol’ government defines passive income as income that is derived through passive activity.
So, if that’s the case should we all get paid for chilling in our loungewear watching Netflix while we work from home? Nothing more passively active than that!
Well, not exactly. This involves activity in either rental property or limited partnerships in which the investor wasn’t actively involved. So, you, for example, invest in real estate and own some rental properties, which generally qualifies you as passive activities to the IRS when you file your taxes.
Because other people are paying you to live in these rental properties you really are sitting in your loungewear watching Netflix and making money when that rent check comes in.
Can you understand why we’re a little obsessed with this? 😬😬 And why we’re even more obsessed with telling other people about it?! This is available to everyone, people!
Of course, there are always losses and that does tend to happen every so often. If you happen to take a loss on this passive income, those losses can offset the passive income you have earned. Unfortunately, it can’t offset active income. Only active losses can offset active income.
Active income refers to income received for performing a service ➡️ such as wages, tips, salaries, commissions, and other income from businesses where you are performing a service. Like working a traditional 9-5 for example. And if there’s anything we can’t stand, it’s trading our time for money.
So if you happen to experience these passive income losses, either in reality or on paper (through the magic of depreciation), unfortunately, you can’t use it to offset your active income. The money you earned. It can only be used to offset other real estate earnings or be carried over to offset future gains.
Passive money plays well with passive income and other passive deals but it doesn’t play well with active income.
How Are Things Different with Real Estate Professional Status?
But, you know us by now and we’ve figured out a way or two to even get around this. And that’s by becoming a real estate professional. In the eyes of the IRS, they see real estate professionals with the ❤️ heart eyes emoji filter over them. When you check the box of being a real estate professional on your taxes, something magical happens. Those “passive activities” no longer qualify as being passive. They bippity boppity boop into being active income.
This ✨ magical difference then allows you to use any real estate losses to decrease the amount of income taxes you are liable for. And yes, it can offset your physician income.
For example, if you show a loss on your taxes of $100,000 on your real estate ventures, and you made a total of $100,000 from your earned active income, the simple math is that the total amount of income that is taxable is $100,000 minus $100,000 equals…
You guessed it, ZERO! They offset each other. Pretty insane, right?
Of course, this really isn’t magic. This is just knowing the system and breaking it down in a way that makes sense. They’re definitely not teaching any of this in schools, which is why so many people are stuck in the hamster wheel day in and day out wondering if there’s any other way.
Now, we’re not asking you to change careers and become real estate agents buuut there is a major difference between a real estate professional (AKA REPS) and a licensed real estate agent. REPS to not require a license or any additional training, it’s just about having the qualifications below.
Are you ready to take a quiz? This is our next segment:
Are You Ready to be a Real Estate Professional?!
Okay, for our first (and only!) question 〰️ According to the IRS, which of the three qualities must you have in order to be a real estate professional?
One 👉 More than one-half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
Two 👉 You currently own property of your own that you have lived in for longer than six months and pay a mortgage on.
Three 👉 You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
If you guessed two and three then you got it! Your prize is being well on your way to understanding how taxes work better than most people. Now, we know that the 750 hours of service in property trades might be a stretch for some of you. That basically means being a real estate professional is your primary job.
And for those of you who are working 50-60 hour work weeks, this is especially tough and it may not make a lot of sense to cut back drastically simply for the status of being a REPS. However, there’s another option.
If your spouse is currently not working or works part-time, this could be a viable path for them. They could qualify by performing the duties of a real estate professional and when you file jointly, both of you are able to enjoy the tax benefits and not sacrifice any crucial income.
The other option is to show that you devoted 750 hours to something you “materially participated in.” Remember that phrase? That means you are being active in the development, management, and operations of the property. You don’t need to manage the property itself, but you will oversee the managers themselves. So you’ll need to prove you spend 750 hours being the managers of managers and making sure nothing gets too out of hand.
It’d be hard to justify your investments in syndications and crowdfunding as active and it would be equally hard to show that you spent all that time simply managing one or two properties. However, in this situation, it helps to have multiple units under your belt increasing how much more time it takes to oversee the property managers. Remember, this is a timing game as well. You’re not going to get here overnight, and there is a learning curve to this. With time comes understanding, and you’ll be savvier in your business ventures.
Lastly, don’t forget we are not tax experts or professionals. Please consult one to see if you qualify in your own specific circumstance. We’re sharing what we know because it works for us and we know it can work for others, too! But you definitely need to put your own time and learning into this process as well.
We’re Keeping it Real
Of course, we will always keep it real with you. And if you’ve been following us for long enough then you already know that. This is why we say, with all love and tenderness, that maybe being a real estate professional isn’t for everyone. For some of you, it might be really difficult to prove that you are spending 750 hours working on real estate ventures on top of your already jam-packed 40 hour week, and then some!
✍️ Documentation is key here. You’ll need to log the hours you spend working on these real estate ventures and what exactly you were working on. Responding to tenants, managing renovations, meetings, etc. The paperwork should be relatively meticulous to demonstrate all of your activities.
As the kids say, they can’t catch you slippin’.
We know we boast about all the benefits of passive income, but hey, if this is the most active it gets with meeting notes and logging maintenance repairs, then we’ll take this over a corporate all-hands meeting any day‼️
The second item to consider is to have a spouse that is willing to participate in your real estate interests and ventures if you yourself wouldn’t necessarily qualify. Ultimately, it would be their name on the form and they would need to be able to complete the hours needed to qualify. We understand this is not always possible and due to other family commitments or circumstances, it can be hard to make happen.
This also means that if you’re not married or filing jointly, you would have to decrease the amount of work you are doing in the clinic to less than 50% than that of your real estate ventures. That is a lot of work to give up and may not be worth it in the long run for you or your family.
That’s why serious conversations are meant to be had about this topic, especially as you listen to these webinars with sponsors. If you feel good about a deal and have done your due diligence, it might be the calculated risk you both agree needs to be made for you and your family.
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