[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
Real Estate Professional Status (REPS) is a powerful tax designation that allows real estate investors to offset active income, such as W-2 earnings, with losses from real estate activities. This can lead to significant tax savings, especially for high-income individuals. For more details on REPS, including the specific criteria and case examples, you can refer to our Primer on Real Estate Professional Status.
However, high-income investors should be aware that there is a cap on the amount of income they can shelter using REPS, particularly when it comes to W-2 income. This limitation does not apply to 1099 income or business income, which makes it a critical consideration for salaried employees.
Understanding the Excess Business Loss Limitation
The Excess Business Loss (EBL) Limitation was introduced under the Tax Cuts and Jobs Act (TCJA) of 2017 and has been extended through 2028 by the Inflation Reduction Act of 2022. This limitation affects noncorporate taxpayers, including those with REPS, by capping the amount of business losses that can be used to offset non-business income.
For 2024, the EBL cap is set at $610,000 for married couples filing jointly and $305,000 for single taxpayers. These amounts are adjusted for inflation each year. This means that while you can create substantial real estate losses, only the amount up to the cap can be used to offset active income in the same year. Any losses exceeding this limit are carried forward to future years as Net Operating Losses (NOLs).
Real-Life Scenario: Impact on High-Income W-2 Earners
This cap specifically impacts W-2 earners because the excess losses that surpass the threshold cannot be immediately deducted against their salary income. For instance, consider a real-life example of a high-income physician who earns $1 million annually. In one year, his spouse acquired 65 apartment units, qualified for REPS and generated $1.25 million in losses from real estate. If the income were 1099 and not W2, they would have been able to shelter all $1 million of earnings and the $250,000 left over would have carried forward to shelter the next year’s income. However, because of EBL, the couple could only offset $610,000 of his W-2 income in 2024, and they would pay taxes on the remaining $390,000. The good news is that the remaining $640,000 would be carried forward as an NOL to offset future income. Note that the doctor’s spouse would not have to qualify for REPS in the future because the NOL was achieved during a year when the spouse achieved REPS and is therefore considered a non-passive loss and stays that way in future years.
Why It’s Different for 1099 and Business Income
The EBL limitation applies differently to 1099 income and business income. This is because these types of income are considered business income and can fully absorb the losses generated by real estate activities, without being subject to the same cap that limits W-2 income. This distinction makes REPS particularly advantageous for entrepreneurs and independent contractors who can effectively shelter a larger portion of their income.
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Wrapping Up
While the Excess Business Loss Limitation does impose a cap on the amount of W-2 income you can shelter with REPS, it does not diminish the overall value of this status. High-income earners can still benefit significantly, especially when combined with strategic tax planning that takes into account the carryforward of excess losses. Understanding these nuances allows you to maximize your tax benefits and plan effectively for the long term
