19 Nov Should A Physician Spouse Qualify As A Real Estate Professional?
The passive activity rules of §469 make it difficult to deduct losses each year from your rental properties. Most rental properties I’ve seen show a tax loss which is largely due to the depreciation, a non-cash expense. This means a property could be cash flow positive but still have a loss for tax purposes.
The problem is that these losses get suspended until you sell the property in a fully taxable transaction (this means doing a §1031 exchange won’t free up your suspended losses). Many times physicians go into real estate investing thinking these losses will offset their physician income only to find out they don’t, at least not until they sell the property.
One way to make current rental losses fully deductible is to qualify as a real estate professional. If you qualify, your rental activities are treated as a regular business and the losses are now fully deductible provided you meet one of the seven material participation tests under §1.469-5T. For direct real estate investment, you will most likely meet one of the seven tests.
For passive activity purposes, a real estate professional is defined in §469(c)(7) as someone who –
- Spends more than one-half of their work in a “real property trade or business”, and
- Spends more than 750 hours in a real property trade or business
A real property trade or business is defined as “any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Unless you own 5 percent or more of the business you’re working for, time spent working as an employee does not count.
For a physician working full-time, it’s difficult if not impossible to meet the one-half of total work and 750-hour test. But if the physician-spouse meets these two tests then it makes the rental losses of the couple fully deductible.
Qualifying as a real estate professional is a factual determination. Did you spend enough time on the right type of activities? In an IRS audit setting, they will want to see time logs and the more contemporaneous and detailed they are the more convincing they will be.
Unless the physician-spouse is a working real estate agent, the time spent on real estate will come from managing the rental properties themselves. This means that the more properties you have the easier it will be to actually reach the 750-hour mark and to convince the IRS you spent that much time.
The best way to qualify as a real estate professional is to keep track of the time spent managing your rentals.
Many physicians invest in real estate but can’t use the valid tax losses to offset their physician income until the property is sold. If the physician-spouse spends 750 hours on real estate and more than half their working time on real estate, they can qualify as a real estate professional. This means that the rental losses go from being suspended to fully deductible each year.
The benefit is timing, getting your losses now rather than later.
If you want your physician-spouse to qualify as a real estate professional, the best practice is to keep a time log during the year. This will aid you in making the right determination at tax time and support your classification should the IRS come calling.