Physicians, like other high wage earners, have very few tax advantages. This is due to the fact that most tax deductions are phased out above a certain level of income.
You’ve probably experienced this when trying to deduct student loan interest or medical expenses only to be told by your accountant that you can’t claim these deductions because of your income level.
Another major factor is their employment status. Physicians are increasingly being employed by hospitals, which means fewer deductions as a W2 wage earner compared to a self-employed physician who can deduct expenses through their clinical practice.
So what options do you have for sheltering your W2 income?
While there are several options (we’ll cover these in future articles), we are going to focus on real estate professional status because it is one of the best ways for physicians to shelter a significant amount of their clinical income. At the same time, you are diversifying your portfolio with real estate and possibly even achieving higher returns than you would from the stock market.
To give you a sense of the magnitude of the benefit, let’s use an example. Let’s say you are married and you make $250,000 as a physician. Your spouse is a homemaker and agrees to be primarily responsible for managing your real estate rentals. In the year your spouse is a real estate professional, let’s say you have $100,000 in losses from your real estate business.
If your spouse does not claim real estate professional status, you are taxed on all $250,000 and your tax liability in 2018 according to the Tax Foundation’s online calculator is $42,819.
If your spouse claims real estate professional status, you can deduct all $100,000 from your $250,000 clinical income. Your are taxed on $150,000 and your tax liability drops to $19,599.
Not only does your taxable income drop significantly, you also fall into a lower tax bracket as your taxable income drops from $250,000 to $150,000.
What happens to the $100,000 in losses in the example where your spouse does not claim real estate professional status? You can’t use any of these losses because of your income level (there are no “special allowances” if you are filing as a married couple and make over $150,000, see IRS Publication 925). These become what are called suspended passive losses. You carry these losses forward until you have a year with passive gains from your rental properties. This could potentially be many years from now as most rental properties operate at a loss on paper (see below for how your property can operate at a loss and at the same time generate cashflow), which means that you miss out on the tax benefits from any rental property loss. The way we see it, any money you can get from tax savings today can start working for you and get you to your goals quicker.
We often get the question – can you claim these suspended passive losses during a year you become a real estate professional? The answer is “no.” The reason is that these suspended losses are passive and they can never offset “active” income like income from your clinical job, only passive income. We will discuss this in more detail in a future article but has implications for timing your losses so they coincide with the year you become a real estate professional.
Real estate professional status (REPS) is simply a designation that anybody can claim on their taxes if you meet two simple criteria. According to the IRS, you qualify if:
In plain language, real estate has to be your primary job – something you work on more than any other job. The other criteria is hours based. As your primary job, you have to work at least 750 hours on real estate activities.
As you can see, you don’t need any special licenses or degrees to get this designation.
One unique aspect of this tax shelter is that for a married couple, only one spouse needs to qualify and the other can continue working full-time in their clinical job. Even though real estate is an investment that benefits both spouses, one can be completely focused on their clinical work and still benefit from real estate deductions.
Below are some examples based on your household situation.
Single: As a single person, it will be harder to qualify because you have to make real estate your primary job while you are still relying on your clinical income to pay for living expenses. For example, let’s say you currently work around 1,500 hours per year as a 0.75 FTE hospitalist. In order to qualify for REPS, you would have to spend more than 1,500 hours a year on real estate activities. While you could cut back to less than 750 hours clinical in order to reduce the hours you have to spend on real estate to 750, you’d be making half the clinical income.
Married with both spouses working: For the spouse who is claiming REPS he/she has to meet the same criteria as the single person above. It’s obviously easier for one spouse to cut back on clinical work because the other spouse is making a full-time clinical income.
Married with one spouse working: In this type of household, the spouse who is not working already meets one of the two criteria (real estate can easily become their primary job), so the only other criteria that has to be met is working on real estate for 750 hours/year.
There is a third criteria that is built into the two criteria above, called material participation. This means that you will need to be actively involved in your real estate investments. For example, buying and renting out apartments or commercial buildings and being involved in the day-to-day management.
You wouldn’t qualify if you are simply putting money into crowdfunding (e.g., PeerStreet) or syndication deals (when you pool money with other investors and buy large apartment complexes) because someone else is doing the day-to-day management of the properties. In other words, you aren’t “materially participating” in your rentals. Material participation is covered in more detail below.
Once you make real estate your primary occupation, the next step is to start investing in real estate so you can meet the 750 hour criteria. As discussed in previous articles, we recommend that you use the buy and hold strategy for cashflow and focus initially on 2-4 unit multifamily residences.
How do you meet the 750 hours of material participation?
Material participation doesn’t necessarily mean that you have to manage those properties yourself – we use property managers for all of our properties. According to Sec. 469(c)(7) of the IRS code, any of the following activities would qualify: “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.”
Kenji does all of the day-to-day management of our properties which includes but not limited to overseeing our property managers (three property management companies and one supported living company), reviewing and analyzing all income and expenses, keeping track of all upcoming lease renewals and determining rent increases and managing the operations of all of our LLCs.
In addition, almost all of our properties undergo significant renovation. Kenji works closely with our contractors and does everything from designing the space, overseeing the work onsite, problem solving issues that inevitably crop up during a renovation and even the occasional swinging of the hammer on demo day.
Meeting the 750 hour rule with only one property will be difficult unless you are doing all of the management yourself. Therefore, we recommend that you try to acquire several properties as quickly as possible.
It is important to point out that normally, the requirement is to spend 750 hours per property. However, if you have several properties, there is a ruling that allows you to combine the real estate activities of all properties into one. In order to qualify, your accountant needs to include the following language in your tax returns:
Under IRC Regulation 1.469-9(g)(3), the taxpayer hereby states that they are a qualifying real estate professional under Code Sec. 469(c)(7), and elect under Code Sec. 469(c)(7)(A) to treat all interests in rental real estate as a single rental real estate activity.
Notice the language: “taxpayer hereby states that they are a qualifying real estate professional.” Your accountant isn’t the one in the line of fire. In the event of an audit, the burden is on you to be able to prove that you qualify for this status. Therefore, one of the most important things you can do throughout the process is to keep detailed notes of your daily activities.
The easiest way to do this is to keep track of everything in a calendar. Tools like Google Calendar enable you to write in detailed notes where you can describe each activity in detail.
Another important thing to do is to set up a separate email account for your real estate business, which will enable you to easily quantify the number of emails you generate to manage your real estate business.
The answer is “yes.” You need to show losses on your real estate activity in order to get a tax benefit.
This may sound counter-intuitive to you – the only way to benefit from this tax shelter is to lose money on real estate?
This is the beauty of real estate. It’s often the case that you’ll show a loss on your tax returns while generating positive cashflow from your properties. Why?
In order to understand why, you’ll need to understand how your taxes are calculated. Taxes are based on net income, which is what you have left over when you subtract all of the expenses from your rental income. Some of these expenses you don’t actually pay for but the IRS let’s you claim them on your taxes. These are sometimes referred to as “phantom expenses.”
Depreciation is one example of a phantom expense. It’s the reduction in value of your property from wear and tear that the IRS lets you deduct. It’s not a true expense. Another is the home office deduction. Setting aside a room in your house for a home office doesn’t really cost you anything. Same with phone/internet. You already buy these services for personal use but you have your rental business cover part of the bill.
Let’s use an example from one of our properties to show you can show a loss for tax purposes but still put money in your pocket (positive cashflow).
You calculate cashflow by subtracting operating expenses from rental income. You don’t include phantom expenses (highlighted in yellow) when calculating cashflow. Note the cashflow on this property is $5,500. This is the amount that we would have in our bank account at the end of the year.
However, when reporting the income and expenses for this property on Schedule E, you include phantom expenses and this puts your income in the negative territory. As a real estate professional, all $5,600 comes off of your W2 clinical income and reduces your tax liability by that amount. Imagine having ten of these properties. You could reduce your tax liability by $56,000.
There’s one other expense that deserves special attention because it is a highly significant expense that most taxpayers rarely utilize. We call it the “$2500 rule.”
When you own rentals, it’s inevitable that things will break down and have to be repaired. You can write these types of repairs off the year you incur the expense. For example, if you pay $200 to repair a leaking dishwasher, you can write off all $200 in your taxes that year.
However, other repairs such as replacing a roof requires that you to spread out the expense over many years, called depreciation. For example, if a roof cost $10,000 and it is depreciated over 27.5 years, you can only deduct $364 each year.
Determining what can be expensed immediately versus what has to be depreciated causes significant headaches for taxpayers, accountants and the IRS. Imagine having 10 properties and 10 repairs for each property. That’s 100 expenses where you have to decide whether or not it should be depreciated.
For this reason, the IRS created an election called de minimis safe harbor. Prior to 2016, the limit was $500. Anything below this threshold could be written off immediately and didn’t have to be depreciated.
Starting with the 2016 tax year, the IRS increased this threshold to $2,500. This means that many more expenses fall into this category.
For example, let’s say you replace a window in your rental property and it costs $2,000. If you make the de minimis safe harbor election, you can write off all $2,000 in one year. If you don’t, you have to depreciate it over 27.5 years and only write off $73 per year.
As you can see, the difference between $2,000 and $73 is huge and will allow you to show even greater losses. Greater losses means more of your clinical income is sheltered.
In order to claim this, you need to ensure that you follow the rules and include the following language in your tax return.
Under IRC Regulation 1.263(a)-1(f), the taxpayer hereby elects to apply the de minimis safe harbor election to all qualifying property placed in service during the tax year.
**Don’t forget to download our Quick Guide on Real Estate Professional Status to use as a reference!**
Decide how you will achieve real estate professional status
Talk to your accountant about real estate professional status and your plans for qualifying for this designation. Understand their requirements. If their requirements sound too stringent or unreasonable, find another accountant. Go to the Facebook community for referrals to real estate investor-friendly accountants.
Commit to investing in real estate with a goal of purchasing as many as possible early on (see other action plans for real estate investing)
Set aside funds for real estate investing and start investing
Track all of your real estate activities very closely.
If you are Physician thinking about investing in Real Estate, you should absolutely check out the Resource Page made by 2 physicians who are financially free thanks to Real Estate Investing!