For years, Dr. Jill Green watched a large chunk of her physician’s salary eaten up by taxes.
“I was paying a ton in taxes and still writing a check for a hefty five-figure amount every year,” she told Business Insider.
When she and her husband started investing in real estate about six years ago to create an additional revenue stream, she learned about a little-known IRS designation called real estate professional status, or REPS.
It’s a strategy some tax experts have nicknamed the “marital loophole.”
The rule allows qualifying investors to use real estate losses to offset W-2 income, something most high earners can’t typically do.
Here’s how Green and other couples are using it to significantly shrink their tax bills while growing their rental portfolios.
Why rental losses usually don’t help high earners
Under normal IRS rules, rental real estate is considered a passive activity. That means rental losses can offset rental income, but they cannot offset W-2 income, such as a physician’s or accountant’s salary.
So if you’re a doctor earning $250,000 and your rental property shows a $150,000 loss on paper, you’re still taxed on the full $250,000.
There is one small exception: a $25,000 “special allowance” for long-term rental losses, but it phases out between $100,000 and $150,000 of income and disappears entirely above $150,000.
For high-income earners, that benefit isn’t an option. If you’re making over $150,000 and you want to use rental losses to offset W-2 income, either you have to be a real estate professional, or you have to be married to one.
That’s where the “marital loophole” comes in.
How REPS works
If one spouse qualifies as a “real estate professional,” rental losses are no longer treated as passive. They become active losses, meaning they can offset active income, including W-2 wages.
“You could continue to have your high W-2 income,” CPA and real estate investor Amanda Han said, “as long as your spouse is a real estate professional, then the rental losses can offset both of your incomes.”
Letizia Alto and Kenji Asakura, both physicians who later scaled back their hospital work after building a large rental portfolio, said they used this strategy to “zero out” their income taxes for seven years and accelerate their path to financial independence.
The strategy hinges on generating tax losses, not necessarily losing money.
It’s common in real estate to produce positive cash flow while showing a loss on your tax return. That’s largely because of depreciation, a non-cash deduction that allows owners to write off a portion of a building’s value each year, as well as deductible expenses like renovations.
The year Asakura qualified for REPS, the couple leaned into upgrades. On paper, those renovation costs — combined with depreciation — helped generate sizable losses. At the same time, the improvements increased the properties’ value and allowed them to raise rents. So, they were improving their portfolio and boosting cash flow while creating paper losses that could offset their physician income.
What it takes to qualify for REPS
You don’t apply for REPS. You qualify based on how you spend your time.
Two main requirements must be met:
- You must spend more than 750 hours a year on real-estate activities
- More than half of your working hours must be in real estate
“You can’t be an attorney working 80 hours a week and then claim REPS,” said Green. “That means you have to be working a minimum of 160 hours in real estate.”
She still works full time as a physician, while her husband, who builds custom closets and garages and manages their real estate portfolio, qualifies. “His work was already considered REPS hours,” she explained.
Documenting your hours is critical. CPA Kristel Espinosa warns that REPS can be closely scrutinized by the IRS.
“You can have other jobs, but you just have to be able to show that to the IRS if ever audited that the real-estate business really is your main thing,” she said.
Asakura logs his hours in a Google Calendar with detailed notes, everything from property visits to replacing an air conditioner.
The short-term rental workaround
If neither spouse can qualify for REPS, or if you’re a single household that doesn’t qualify, there’s another strategy known as the “short-term rental tax loophole.”
The IRS treats short-term rentals (where the average guest stay is seven days or fewer) differently. If the owner materially participates in managing the property, losses may be used to offset W-2 income, even without REPS.
To qualify, investors must meet one of several material participation requirements. The most common are:
- Spending at least 500 hours on the property
- Spending at least 100 hours, and no one else spends more time
- Spending more hours than everyone else combined
For example, if an investor spends 80 hours managing a short-term rental and cleaners and landscapers spend 50 hours total, the investor may still qualify under the “more than everyone else combined” test.
Han gives the example of someone earning $500,000 a year in W-2 income.
“If you invest in a long-term rental and you can’t use it to offset the tax, then maybe you’re paying 37% taxes on it,” she explained. However, if you turn that property into a short-term rental and generate a $200,000 tax loss, “that offsets your W-2, so maybe you’re saving $74,000 in taxes.”
Unlike the $25,000 long-term rental allowance, this strategy has no income cap.
“For people with lower income, it’s even more impactful,” Han said. “If you make $1 million and you save some tax, great. It’s not life-changing. But if you’re making $80,000 and you save a significant amount in taxes, that’s a lot more money to invest for that specific taxpayer.”
Read the full article here
