Under the right circumstances, qualifying as a real estate professional can allow you to deduct otherwise limited rental losses, avoid the 3.8% Medicare tax on rental income, and create a more flexible and aggressive tax strategy. But there are critical requirements and limitations you need to understand—especially if you live in California.
Real Estate Professional Tax Status: Unlocking Tax Benefits for Active Investors in California
If you’re a high-income earner and/or have rental properties in Newport Beach or elsewhere that could be used to further offset income, there’s a powerful—but often misunderstood—IRS designation that could significantly reduce your tax burden: Real Estate Professional Tax Status (“REP Status”).
Under the right circumstances, qualifying as a real estate professional can allow you to deduct otherwise limited rental losses, avoid the 3.8% Medicare tax on rental income, and create a more flexible and aggressive tax strategy. But there are critical requirements and limitations you need to understand—especially if you live in California.
The Real Benefits: Why Real Estate Professional (“REP”) Status Matters
- Deduct Rental Losses Against W-2 or Other Active Income: Most investors can only deduct rental losses against other passive income. REPs can treat those losses as non-passive and deduct them against any income.
- Use Depreciation to Its Full Potential: Passive investors often have to carry forward depreciation losses. REPs can use them now to reduce current tax liability.
- Avoid the 3.8% Net Investment Income Tax (NIIT): REPs who materially participate can exclude rental income from NIIT, under IRC § 1411 and Treasury Reg. § 1.1411-4.
- Strategic Tax Planning Flexibility: REP status opens the door for long-term strategies including income shifting, loss harvesting, and deduction acceleration.
The Requirements: Who Qualifies as a Real Estate Professional?
To qualify under IRC § 469(c)(7), you must meet both tests within the same tax year:
- 50% Test: More than half your personal services must be in real property trades or businesses.
- 750-Hour Test: You must spend at least 750 hours in real property trades or businesses where you materially participate.
Real property trades or businesses include development, construction, acquisition, rental, operation, management, and brokerage (excluding mortgage brokerage). If you’re a W-2 employee in a real estate business, your time doesn’t count unless you own more than 5% of the business.
What Counts Toward Your Hours? And What Doesn’t?
For Newport Beach, Costa Mesa, and coastal Orange County rental property owners, valid REP time includes:
Activities That Count
- Property management and oversight
- Tenant screening, rent collection
- Contractor supervision and repairs
- Compliance tasks like reviewing local landlord-tenant laws
- Managing HOAs, paying insurance and taxes
- Handling lease renewals, evictions, and inspections
Activities That Don’t Count
- Commuting to properties
- Studying for real estate licenses
- Reading general newsletters or unrelated articles
- Reviewing deals for potential investments without active involvement
- Investor-only oversight without operations
Important: This can be a grey area with time spent and activities counting towards the requirement. For example, reviewing legal updates does count when it directly supports the operation of your rentals—especially relevant for landlord-tenant compliance in areas like Newport Beach and Costa Mesa. So reading a real estate blog such as this may no count; but reading our blog on, for example, rent control ordinances, so that you’re staying atop of the legal requirements specific to your property, could count.
Material Participation: How You Prove It
Even if you meet the 50% test and 750-hour test required to qualify as a Real Estate Professional under IRC § 469(c)(7), you must also demonstrate material participation in each rental activity. These are separate requirements—the 750-hour and 50% rules establish your status as a Real Estate Professional, but you still need to show that you materially participated in the day-to-day operations of the properties you claim active involvement in.
The IRS provides seven material participation tests under Treasury Regulation § 1.469-5T. You only need to meet one to qualify:
- 500-Hour Test: You participated in the activity for more than 500 hours during the tax year.
- Substantially All Test: You did substantially all the work in the activity.
- 100-Hour Test (and Most Active): You participated at least 100 hours and no one else (including contractors or property managers) participated more than you.
- Significant Participation Activities (SPA) Test: Your participation in all significant participation activities (each more than 100 hours) exceeds 500 total hours.
- 5-Out-of-10 Test: You materially participated in the activity in any five of the prior ten years.
- Personal Service Activity Test: You materially participated in the activity in any three prior years and it was a personal service activity (like law, health care, consulting, etc.).
- Facts and Circumstances Test: Based on all the facts, you participated in the activity on a regular, continuous, and substantial basis. (This is rarely relied upon because it is subjective and hard to prove.)
Important Distinction: The 750-hour/50% rule determines if you are a “real estate professional” generally, while the material participation tests apply to each activity unless you elect to treat all your rentals as one combined activity (Reg. § 1.469-9(g)).
You can also elect to aggregate all your rental properties into one activity (Reg. § 1.469-9(g)), which is especially useful if you own multiple properties.
Tip: Keep contemporaneous records like calendars, timesheets, or property logs. The burden of proof is on you. Courts have rejected vague or retroactively prepared logs—see Zaid Hakkak v. Comm’r (2020) and Sezonov v. Comm’r (2022).
California Doesn’t Follow the Federal REP Rule
Even if you qualify for REP status federally, California still treats your rental activity as passive. Rental losses can’t offset W-2 or business income on your state return.
Real Court Cases: What Not to Do
- Drocella v. Comm’r (2023): Six properties, full-time job—failed to prove time split.
- Dunn v. Comm’r (2022): No aggregation election, poor records—losses disallowed.
- Sezonov v. Comm’r (2022): Logs estimated after-the-fact—deemed unreliable.
- Zaid Hakkak v. Comm’r (2020): Ballpark guesses? Doesn’t fly with the IRS.
Is REP Status Worth It?
Yes—if you qualify and document it properly. The tax savings can be significant, especially for real estate owners in high-income areas like Newport Beach, Costa Mesa, and coastal Orange County.
Need Help Navigating REP Status?
At Lucas Real Estate Group, based in Newport Beach, we help clients across Orange County navigate real estate sales, tax strategies, and legal compliance. Whether you’re a full-time investor or managing rentals on the side, our legal and real estate team can guide you through qualification, documentation, and tax planning.
Call or email anytime: info@lucas-real-estate.com or 949-478-1623.
Sources
- IRS Publication 925 (2024)
- IRC § 469(c)(7)
- Treasury Reg. § 1.469-5T
- Treasury Reg. § 1.1411-4
- California FTB Pub. 1001
Questions or Need Help?
Thinking of selling California real estate? We’d love the opportunity to assist – we provide full-service sales and property management in Newport Beach, Costa Mesa and surrounding areas. Call or email anytime: info@lucas-real-estate.com or 949-478-1623.
Author Devin R. Lucas is a Real Estate Broker, REALTOR®, and Real Estate Attorney specializing in Newport Beach, Costa Mesa, and Orange County coastal communities. Courtney Lucas, a licensed CPA, Real Estate Salesperson, and REALTOR®, provides expert financial insight alongside real estate services.
Lucas Real Estate offers unmatched expertise in California real estate sales, property management, capital gains strategies, and property tax matters, including Propositions 13, 58, 193, 60, 90, and new Proposition 19.
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