High-income earners are increasingly turning to a specific IRS designation to significantly reduce their tax liabilities. By leveraging real estate investments, some professionals are using paper losses from properties to offset their primary salaries, a strategy that can save them tens of thousands of dollars annually.
The strategy, known as achieving Real Estate Professional Status (REPS), is particularly effective for married couples where one partner can dedicate significant time to managing a property portfolio. This allows the household to treat rental losses as active losses, directly reducing their taxable income from other jobs.
Key Takeaways
- Real Estate Professional Status (REPS) allows qualifying investors to use rental property losses to offset W-2 income.
- This strategy is often called the "marital loophole" when one spouse qualifies, benefiting the couple's joint tax filing.
- Qualification requires spending over 750 hours and more than half of one's working time on real estate activities annually.
- An alternative for those who don't qualify for REPS is the short-term rental strategy, which has different participation rules.
Understanding the Standard Tax Rules for Rentals
For most people, real estate investing is considered a "passive activity" by the Internal Revenue Service (IRS). This classification has major tax implications. Any financial losses generated from a rental property, such as those from maintenance, mortgage interest, or depreciation, can typically only be used to offset income from other passive activities, like income from another rental property.
These passive losses generally cannot be used to reduce taxes on "active" income, which includes salaries and wages from a regular job. For example, a doctor earning $250,000 with a $50,000 paper loss on a rental property would still be taxed on their full $250,000 salary.
The High-Earner Limitation
While there is a special allowance that lets some taxpayers deduct up to $25,000 in rental losses against their regular income, this benefit is phased out for those with a modified adjusted gross income between $100,000 and $150,000. For individuals earning more than $150,000, this deduction is unavailable, leaving them unable to benefit from rental losses on their main income.
The Real Estate Professional Status Solution
This is where Real Estate Professional Status (REPS) changes the equation. If an individual or their spouse qualifies, the IRS no longer treats their rental activities as passive. Instead, the losses become active losses, meaning they can be deducted directly against active income, including high W-2 salaries.
Physicians Letizia Alto and Kenji Asakura are examples of professionals who have used this strategy. They reported using REPS to eliminate their income tax liability for seven consecutive years, which helped them build their real estate portfolio and achieve financial independence more quickly.
Dr. Jill Green, another physician, shared a similar experience. She noted paying a "hefty five-figure amount" in taxes each year before she and her husband began investing in real estate. By having her husband qualify for REPS, they were able to use losses from their properties to offset her physician's salary.
How Paper Losses Generate Real Savings
It's important to understand that these "losses" are often on paper for tax purposes and do not necessarily mean the properties are losing money. A key factor is depreciation, a non-cash deduction that allows property owners to write off the value of a building over time.
"You could continue to have your high W-2 income," said CPA and real estate investor Amanda Han, explaining that as long as a spouse qualifies as a real estate professional, "the rental losses can offset both of your incomes."
When combined with deductible expenses from renovations and upgrades, depreciation can create a significant paper loss. Investors can simultaneously improve their property's value and increase rental income while generating a tax loss that provides immediate financial benefits.
Meeting the Strict IRS Requirements
Qualifying for REPS is not a simple application process; it is based on how an individual spends their time. The IRS has two primary tests that must be met each year:
- The 750-Hour Test: The individual must spend more than 750 hours during the tax year in real property trades or businesses in which they materially participate.
- The Half-Your-Time Test: The time spent on real estate activities must constitute more than half of the total time the individual spends working in all personal services during the year.
Meticulous Record-Keeping is Essential
Because REPS can be closely scrutinized by the IRS, maintaining detailed logs of time spent on real estate activities is critical. Kenji Asakura, for instance, uses a Google Calendar to document every hour, from property visits to time spent replacing an air conditioner.
These rules make it difficult for someone with a demanding full-time job, like a surgeon or lawyer, to qualify on their own. However, if their spouse can meet the requirements, the entire household can benefit. This is why the strategy is often referred to as the "marital loophole."
An Alternative Path The Short-Term Rental Strategy
For single individuals or couples where neither spouse can meet the demanding REPS requirements, another tax strategy exists involving short-term rentals.
The IRS treats properties where the average guest stay is seven days or fewer differently from long-term rentals. If the owner "materially participates" in managing the property, losses can be used to offset W-2 income even without REPS. This strategy has no income cap.
Qualifying for Material Participation
There are several tests for material participation, but the most common ones include:
- Spending at least 500 hours on the property during the year.
- Spending at least 100 hours, provided no other individual spends more time.
- Spending more time than anyone else combined (e.g., cleaners, maintenance).
This loophole allows high-income earners who actively manage a vacation rental to achieve similar tax benefits to those with REPS. For example, an investor earning $500,000 could use a $200,000 paper loss from a short-term rental to save an estimated $74,000 in federal taxes, assuming a 37% tax bracket. This can turn a tax burden into an opportunity for reinvestment and portfolio growth.
