If you’ve spent any time on LinkedIn, you’ve probably seen posts from someone who has real estate professional status talking about how they reduced their income taxes and have become full time real estate investors.

While their claims may not technically be false, they can be misleading. Because for the vast majority of passive investors, real estate investing will not lower your income tax. Keep reading to understand what this means, and to learn one strategy you can use to actually save on your income taxes while expecting to generate consistent future returns. 

Understanding The “Real Estate Professional” Classification 

The person you follow on LinkedIn might be telling the truth about the benefits they’ve experienced from investing in real estate, but that doesn’t mean those same benefits will apply to your investments. 

The only time that real estate investments will actually lower your earned income tax is if you meet the IRS criteria for classification as a real estate professional. 

According to the IRS, to classify as a real estate professional, you must:

• Spend more than 50% of your time in real property businesses (development, construction, management, brokerage, etc.)
• Have at least 5% ownership in the real property businesses you’re working for 
• Materially participate in every real estate transaction you claim deductions for 
• Work in real property businesses for more than 750 hours in the year 

If you’re a busy, high-paid professional — especially one with a dual income — it is nearly impossible to meet all of these criteria. And if you’re not classified by the IRS as a real estate professional, any tax deductions you claim on your real estate investments will typically not affect your earned, W-2 income tax.

Should You Invest in Real Estate?

Real estate may not lower your income tax, but it does offer other benefits that passive investors can take advantage of. Just make sure you know what you can realistically expect to qualify for and plan accordingly. 

Say, for example, that you make $500,000 from your corporate job this year, and you invest $100,000 of it into a rental property. Your $500,000 of income will generally be taxed at the highest federal rate, around 35%. However, the returns you generate from your rental property will be taxed at a lower rate than the 35%, thanks to incentives like depreciation. 

We often illustrate this idea by talking about the two tax buckets. Returns you earn in the passive income bucket are expected to be taxed at a lower rate, but that doesn’t impact your earned (W-2) income bucket. 

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Disclaimer: All income and tax figures are used strictly for illustrative purposes. Please check with your tax and legal professional as First Generation Capital Partners does not provide tax or legal advice and the above is not intended to or should be construed as such advice. Your specific circumstances may, and likely will, vary.