If you own residential rental property and don’t qualify as a real estate professional yourself, now is the time to marry one. Doing so can save you a bundle in taxes.
The term “real estate professional” is an IRS tax classification. To qualify, you must work a sufficient number of hours each year at one or more real estate business. There are some significant benefits to qualifying as a real estate pro if you own rental property. Moreover, these benefits are greater today than they have ever been.
First, being a real estate professional will prove very beneficial if—as is often the case—your rentals lose money each year. This is because, unlike everybody else who owns rentals, real estate professionals are not subject to the IRS’s dreaded passive loss rules (IRS Publication 925, Passive Activity and At-Risk Rules). These rules prevent many landlords from deducting losses from their real estate rentals from their other non-rental income until they sell the property.
If you qualify as a real estate professional and materially participate in your rental activity, you don't have to worry about the passive loss rules. You can deduct all your rental losses from your non-rental income. However, during 2018 through 2025 there is a limit on the total business losses that may be deducted each year, including rental business losses. Married taxpayers filing jointly can deduct $500,000 per year, single taxpayers can deduct $250,000. So no more than $250,000/$500,000 in real losses can be deducted during these years.
But wait, it gets even better. Real estate professionals also are not subject to the Net Investment Income tax (NII tax). The NII tax is a separate flat 3.8% income tax on unearned income, including rental income and gains from selling rental property. You're only subject to the NII tax if your adjusted gross income for the year exceeds $200,000 if you're single, or $250,000 if you're married filing jointly ($125,000 for marrieds filing separately). Many high income landlords have to pay this extra 3.8% tax—but not those who qualify as real estate professionals. The NII tax does not apply to them.
Okay, you’re sold on the idea that you want to be a real estate professional. How do you achieve this exalted status? To qualify, you must spend (1) over 50% of your work time in a real estate business or businesses, and (2) over 750 hours working in all your real estate businesses during the year. As a rule, people with full-time jobs outside of real estate cannot qualify. In addition, to avoid the passive loss rules and NII tax, you must materially participate in your rental activity. There are various methods to establish material participation. The two most common are working over 500 hours at the activity during the year, or working 100 hours and more than anyone else.
If you have a full-time job that is not in a real estate business, you won’t be able to qualify as a real estate professional. But all is not lost. If you’re married and file a joint return, the time your spouse works at real estate businesses can qualify you both as real estate professionals. If your spouse can pass the 750 hour and 51% tests, you both benefit from his or her real estate professional status. Moreover, you can combine your time with your spouse’s to help pass the material participation requirement.
So, if you can’t qualify as a real estate professional yourself, but you own rentals, all you have to do is marry a person who can qualify. Your new spouse can count the time he or she works managing your rentals, and the time he or she spends in other real estate business, such as working as a real estate agent. When you file your joint return, neither the passive loss rules nor NII tax will apply to you. Thus, you’ll benefit whether your rentals earn a profit or incur a loss.
Example: Dr. Jones is a busy single physician who also owns two dozen rental units, that incur losses of $50,000 each year. He can’t deduct any of these losses from the $250,000 he earns each year from his medical practice. The good doctor marries Joan, a real estate agent. She manages the rental units and continues to work at her agent business part-time. She qualifies as a real estate professional and spends sufficient time managing the rental properties so that they are exempt from the passive loss rules. When Dr. Jones and Joan file their joint return, they can deduct their $50,000 loss from Dr. Jones’ other income. They save $17,500 in federal income tax. What a great basis for a successful marriage!
See the IRS FAQ on NII tax for more on the subject.