You've probably heard the old saying, “It's not what you earn, it's what you keep.” Unfortunately, physicians simply don't have many tax advantages available to us, so we end up paying a significant amount in taxes to go along with our higher incomes.
However, I discovered that there are some physicians who utilize something called the Real Estate Professional Status (REPS) to their advantage and are able to significantly reduce their tax burden. My friends at SemiRetiredMD are two of them.
Have you ever heard of this designation? Well, if you're already investing in real estate, simply being a real estate professional could save you a huge amount of money when it comes to paying taxes. And yes, this is completely legal.
Intrigued? Yes, so was I when I first heard about it. Here's what I know…
Passive vs Active Income
I've spent a ton of time on this blog defining “passive income” but the government has its own definition. The government defines passive income as income that is derived through passive activity (super clear, right?). This involves activity in either rental property or limited partnerships in which the investor wasn't actively involved.
So, if you invest in real estate and own some rental properties, that generally qualifies as passive activities to the IRS when you file your taxes.
If you happen to take a loss on this passive income, those losses can offset passive income you've earned. Unfortunately it can't offset active income. Only active losses can offset active income.
So if you happen to experience these passive losses, either in reality or on paper (through the magic of depreciation), unfortunately you can't use it to offset your physician income. It can only be used to offset other real estate earnings or be carried over to offset future gains.
How Are Things Different With Real Estate Professional Status?
However, if you are a real estate professional in the eyes of the IRS, things change quite a bit. When you check the box of being a real estate professional on your taxes, these “passive” activities no longer qualify as being passive. In fact, they're considered active.
This big step then allows you to use any real estate losses to decrease the amount of income taxes you are liable for. And yes, it can then offset your physician income.
For example, if you show a loss of $50,000 on your real estate ventures, and you made a total of $200,000 from your clinical work, the simple math is that total amount of income that is taxable is $200,000 – $50,000 = $150,000. Pretty powerful. Not to mention, that could also drop you into a lower tax bracket.
FYI, real estate professional status is not the same thing as being a licensed real estate agent. REPS does not require a license or any additional training. It's just about the qualifications below…
So How Do You Qualify For Real Estate Professional Status (REPS)?
According to the IRS, to qualify for REPS you must meet both of the following conditions:
- 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.
- You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.
This is a bit tricky because you basically need to claim that being a real estate professional is your primary profession. That would simply mean that you would need to spend more hours in real estate than in your clinical job.
That might be hard to justify if you're working a 50-60 hour week, and it may not make sense to cut back that drastically simply for this status, but 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. That way, you both can reap the tax benefits if you file jointly, and yet, not sacrifice your clinical income.
You also have to show that you devoted 750 hours to something you “materially participated in.” This term is defined as being active in the development, management, and operations of the property. You don't necessarily need to manage the property yourself but you have to at least oversee the property managers.
It'd be hard to justify your investments in syndications and crowdfunding as active and it'd be equally hard to show that you spent all that time simply managing one or two properties. There's no magic number but it helps to have multiple units under your belt.
Disclaimer: As you know, I am not a tax professional, please consult one to see if you qualify in your own specific circumstance.
That being said, becoming a real estate professional is not for everyone.
First off, you have to be able to prove that you are spending at least 750 hours working on your real estate ventures.
It is not only important to keep a log of the hours you've spent, but also what exactly you've been doing during that time (responding to tenants, managing renovation, meetings, etc.) The paperwork should be relatively meticulous to demonstrate all of your activities.
You also have to have a spouse who is willing to participate in your real estate interests if you yourself wouldn't qualify. Ultimately, it would be their name on the form and they would need to be able to complete with the hours needed to qualify. This is not always possible due to family circumstances or other time commitments.
If you are not married/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 it might not be worth it in the long run.
Becoming a real estate professional isn’t for everyone. However, if you're looking for strategies to minimize your tax burden as a physician, consider this a very powerful one.
Am I a Real Estate Professional?
Well, having reduced my clinical hours to closer to .5 FTE, and having the requisite number of professional activities to satisfy the 750 hours, I am planning on claiming REPS this year. I have a decent amount of carried losses from my real estate investments. I also could take advantage of something called accelerated depreciation to increase my losses this year.
This all could lead to a very good year in terms of tax payouts. I'll keep you updated…
Again, if you're interested in it, I recommend reaching out to your CPA and ask if it's relevant for you.