Ever heard someone in a high income profession saying they pay zero dollars in taxes? We often talk about the tax benefits of real estate investing, of which there are several, but the one that tends to get the most attention in our physician communities is the famed Real Estate Professional Status (REPS). This tax status actually allows you to use some of those paper losses (depreciation) from your real estate properties – even if your properties are cashflowing and generating income – and count them against your physician or other income on your taxes in order to reduce the overall amount of your total earnings that you pay taxes on. While this sounds incredible and is one of the largest potential benefits of and deductions associated with investing in real estate as an active investor, it is also complicated and can only be claimed in specific circumstances. If you’re thinking about investing in real estate specifically and solely for this reason, make sure you understand the nuances of claiming this on your taxes and speak to an accountant to ensure that you would be willing to do all the things necessary to meet criteria before running out to invest in long term rental properties as a physician. This article covers how REPS works, who qualifies to take advantage of it, and other things to know about implementing this into your tax strategy as a physician.
Disclaimer: As always, note that we are not accountants or lawyers, and this information is for general informational purposes only. You should consult appropriate expertise before taking action based on this information, which is neither guaranteed to be up to date and accurate nor individualized to your personal situation. While we’ve attempted to convey accurate information to the best of our knowledge, always confirm any information you learn about on our platforms with a licensed professional or official resource. To learn more, visit our disclaimers and disclosures.
Quick Links
Resources
Learn more about active real estate investing through our additional educational resources:
What is Real Estate Professional Status (REPS), and why is it so exciting for doctors?
Physicians are always looking for ways to be more tax savvy, especially as there are only a limited number of tax deductions available to physicians who are paid as W2. Real estate has long been seen as a tax advantaged way to invest. However, in many cases, the tax advantages of real estate, especially if you engage in passive investing in real estate, can only be used to offset passive income streams. With real estate professional status, there is the ability to actually offset your W2 or 1099 income as a physician or other side gigs with the tax advantages of real estate.
The majority of these benefits come through the use of depreciation, which we talk about in more detail in the next section. Essentially, the IRS allows you to “depreciate” the value of your property over a period of time per a certain schedule, even though your real estate investments are generating profit. The value of this depreciation is why many people’s cashflow from real estate is tax advantaged. You can claim this paper “loss” from depreciation on your taxes to offset the income that is generated from your properties. Typically, you can only use this depreciation to offset passive income, which your day job as a physician does not count as. If you qualify for REPS, you can actually take that depreciation against your W2 income as well, which is how some people who invest heavily in real estate can claim they pay very little to nothing in taxes despite having a respectable income such as that which most physicians have.
It’s important to note that this is not an easy thing to claim. There are strict criteria that must be met, and that the IRS examines critically, so it’s important to both ensure that you would meet that criteria if subjected to an audit and that you work with an accountant who is experienced in real estate to help you navigate the rules and documentation.
What is depreciation in real estate?
Depreciation is essentially a phantom expense that accounts for the perceived deterioration of the value of your property over time as things like your roof and your floors decrease in value. It takes that value all the way down to zero over time. Typically, this occurs evenly over a course of 27.5 years, so ~3.6% of the purchase price per year. However, you may hear some people talking about accelerated depreciation, in which you can actually depreciate a greater value in the first year(s) of ownership by doing things such as a cost segregation study.
If this is confusing to you because you instinctively think about real estate as appreciating instead of depreciating, it may make more sense to think about this like a car. We all know that the value of your car decreases the minute you drive it off the lot, and typically continues to lose value over time, even if it’s still functioning perfectly well 20 years from now, unless it happens to be some sort of unique collectible. The IRS thinks of rental properties in this way, because maintenance costs go up, things need to be replaced, etc.
Do you have to be a realtor to claim REPS?
No. This has nothing to do with being a realtor.
Real estate professional status is a tax status contingent on fulfilling the criteria to claim this status on your taxes. The baseline assumption by the IRS with rental activities is that they are passive, so REPS is a way of saying that your rental activities are not in fact passive, but active, thus allowing you to count your real estate paper losses against active income.
What are the criteria to meet Real Estate Professional Status (REPS)?
The main criteria to qualify for real estate professional status are as follows (you must meet all of them, not just one of them):
Real estate must occupy >50% of your professional time, or more than anything else.
You (or your spouse, if married filing jointly) must spend over 50% of your professional time on your real estate endeavor. Therefore, the IRS must be able to see that it occupies the majority of that person’s time. If you work 80 hours a week as a physician, you will not pass the sniff test.
If you’re married filing jointly, only one of you has to qualify in order to claim this on your tax return and get the benefit.
750 hours spent on your real estate related services during the tax year in real property trades or businesses, in which you materially participate (defined further below) in the following types of activities:
Property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, and/or brokerage
These must be active managerial activities, not investor activities, so it’s on the ground work done by those who work in real estate - finding tenants, managing renovations, etc
Examples of things that do NOT definitely count towards these hours, as they are considered investor activities, not managerial activities: learning about real estate investing, researching real estate investment opportunities or properties, handling the finances of your real estate investments in a “non-managerial capacity” or reviewing financial statements
While some people will tell you that education and research hours may count, this is subject to interpretation and this is case law to suggest that it most likely will not if any substantial quantity. This is because these tend to be considered “investor” type activity and not essential to running to properties on a daily basis.
Remember, this is in addition to the real estate occupying >50% of your professional time, so you can’t do 1000 hours of real estate but work more than that as a physician and still qualify for REPS.
A note on “material participation” in criteria #2: This is really where the rubber meets the road in needing to meet scrutiny, and where people can get in a lot of trouble for exaggerating the extent of their involvement. You are going to want solid documentation that you meet these criteria.
There are currently 7 ways to meet the material participation requirement, and the person claiming REPS status must be involved in these activities on a regular, continuous, and substantial basis.
We go over details of material participation criteria below, as it is quite nuanced, and some of you may already be concluding that this is not going to work for you.
The person claiming REPS status has to materially participate in each passive activity separately. What this effectively translates to is that for each property, you’re going to have to show material participation in each one individually in order to count their tax benefits.
There are ways to get around this by grouping the properties, but that can have major long term tax consequences for each of the properties in the group, so before jumping to this you really need to talk to a CPA and see if it’s worth it.
Importantly, if you are a couple that files your taxes as married filing jointly, the spouse claiming this status must qualify for the first two criteria on their own. You can NOT combine your service hours to achieve real estate professional status. For material participation criteria, a couple that files jointly can combine hours, so only one spouse has to qualify as REPS, but both spouses’ hours towards rental activities can be used to qualify for material participation.
As you can see, there are many nuances to this status, and it’s not easy to qualify unless you really do want to make real estate a substantial part of your working life.
You are going to want to talk to a professional familiar with REPS, such as an accountant that specializes in real estate. Also, this information is always subject to change, so make sure you confirm all information and stay up to date on it. Again, we are not tax professionals and you should do your own due diligence before counting on being able to take this status based on any information on this page.
How can a physician possibly meet REPS Status? I work full time as a doctor.
The fact is that if you work full time as a physician, you probably can’t meet this requirement as yourself. 750 hours is a lot of time - spread over 52 weeks a year, this means that you would be working an average of 14-15 hours a week on real estate, and again, not just by hanging out online looking for properties or managing the finances, but actually doing the on the ground work in a way that counts as material participation.
And yet, many physician families claim this. They fall into one of two categories:
The spouse of the physician works part time or doesn’t work and can meet the criteria.
The physician themselves cuts back enough at work so that the majority of their professional time is spent on real estate activities.
What does life as someone that has REPS status look like, and is REPS worth it?
The fact is that if you are going to claim REPS status for your work managing your rental properties, you’re going to be the one on the ground doing most of the work. This is not the same as buying a rental property, hiring a property manager, and cashing the checks as they come in. For the most part, you’re going to have to be the one that’s managing your tenants, maintaining and renovating the property, and going and picking out and buying the materials. While you can contract some of that out, you still have to meet that criteria of doing more than anyone else.
You’re also probably not going to be able to meet the criteria with just one property. In order to get 750 hours doing these activities, you’re probably going to need at minimum a few properties. Sure, there are probably some situations where you pour many hours into completely renovating, rehabbing, and decorating a particular property and that is really your job for the year, but at this point, you also have to consider whether the depreciation from that one property is worth all that effort. It’s most likely not going to make sense at a small scale.
However, if you’ve got 10 properties or larger properties, and your spouse is doing all the higher level work managing them, you could quickly see how all the depreciation from those properties combined would offset your physician income and become worth it.
What counts as “material participation” for the purposes of REPS?
If you’re still reading, this is where we get into nuances. You will want to verify all of these things with your accountant. The IRS feels that you have materially participated for a tax year if you satisfy any of the following tests, quoted directly from the IRS site so we don’t mess it up:
You participated in the activity for more than 500 hours.
Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you didn’t materially participate under any of the material participation tests, other than this test. See Significant Participation Passive Activities under Recharacterization of Passive Income, later.
You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital isn’t a material income-producing factor.
Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
The IRS adds a caveat to this one by stating: You didn’t materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity doesn’t count in determining whether you materially participated under this test if:
Any person other than you received compensation for managing the activity, or
Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
A note for those physicians who invest in real estate syndications passively in addition to claiming REPS: If you are a limited partner in a real estate venture and want to also use those depreciation losses towards your W2 income, you can only establish material participation by meeting criteria 1, 5, or 6 for those real estate activities.
What things does the IRS see as red flags when somebody claims REPS Status?
There are several things that may raise red flags immediately with the IRS if your claim of material participation is challenged. Some examples we’ve heard of include:
Your property or properties are very far from where you live.
You have a day job that constitutes more than 40 hours a week.
You are using a property manager or property management company for the day to day operations.
The majority of activities you’re claiming for your status are not essential functions of owning a real estate property - i.e. the business would function relatively fine without you.
What things do I need to document to meet REPS Status, and how can I be sure that I can claim it?
Again, you’re going to want to document, document, document.
Document phone calls, trips out to the property, conversations with tenants, time spent making repairs, etc etc. Keep all emails, receipts, credit card statements, bank statements, cell phone records, and anything else that would help you substantiate your claims if audited.
Most real estate accountants will tell you that this requires a daily log (or close to thereof), as the IRS does not have to honor estimates. If audited, you want the burden of proof to be on them to prove that you didn’t do the things that you did, rather than asking them to just believe you based on guesstimates. Many real estate savvy accountants will also tell you to maintain a log of non real estate activities that you do professionally or other side gigs to prove that the majority of your time working really was on real estate.
Another word of caution - be wary of accountants that claim that they help many people with REPS if they don’t hold you to extremely high standards when it comes to claiming REPS. Anecdotally, the IRS has been known to look at other clients of an accountant or accounting firm if they find one client has taken REPS without meeting criteria, and if they see that the next handful of clients also don’t meet REPS, they may decide to audit everyone that accountant has filed for.
I heard you can claim REPS more easily if you invest in short term rentals. Is this true?
Not exactly, but it is true that you can qualify for the same way to use depreciation against your ordinary income as a physician by investing in short term rentals, WITHOUT the requirement that you meet the 750 hours and do real estate more than anything else. We refer to this as the . short term rental tax loophole.
Because the IRS does not consider short term rentals (a property used for stays that average seven days or less, usually what we think of as those seen on AirBNB and VRBO) as rental activities, they have separate rules for these properties. However you still have to meet the material participation requirements, which means you should be managing them yourself.
In this situation, many people will use accelerated depreciation on the properties, take the advantages of depreciation, and then either hand the properties over to a property manager or convert it to a long term rental to make the activity more passive long term once the benefits of depreciation have been fully realized on the property.
Learn more on our page on short term rental properties.
Conclusion
If you haven’t figured this out already in this article, the IRS means business when they see people taking the size deductions that they are able to take with REPS status. While this is a VERY powerful tax strategy, it is only useful if you truly intend to make real estate the majority of what you (or as applicable, your spouse) do/does. Before you run out and buy your first long term rental property or mid term rental property under the assumption that it’s going to land you a huge tax deduction, read through this article in detail and talk to an accountant versed in these matters. If you were going to buy the property regardless, and REPS is icing on the cake, this is the ideal situation.