[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
For real estate investors, achieving Real Estate Professional Status (REPS) is a significant advantage because this designation allows you to use real estate losses, including those from accelerated depreciation, to offset active income such as W-2 or 1099 earnings. However, if you live in California, it’s crucial to understand that the state does not recognize REPS for state income tax purposes. This means that while you can still shelter your federal income with real estate losses, those benefits do not extend to your California state taxes.
Understanding Real Estate Professional Status (REPS)
Before diving into California’s specific rules, let’s briefly recap what REPS entails. The REPS designation allows taxpayers to treat real estate losses as non-passive, which means you can use these losses to offset other types of active income. For detailed criteria and examples, you can refer to our Primer on Real Estate Professional Status, where we discuss the requirements, such as the 750-hour rule and material participation.
California’s Non-Recognition of REPS and Accelerated Depreciation
In California, the situation is different. The state does not conform to federal rules regarding REPS, which means that California residents cannot use real estate losses, including those from accelerated depreciation, to offset their state income taxes. However, these losses can still be used to reduce your federal tax liability, which is typically a larger portion of your overall tax burden.
Additionally, California does not fully align with federal rules on accelerated depreciation. Specifically, California does not allow the additional first-year bonus depreciation (IRC Section 168(k)) that is permitted at the federal level. Instead, California requires that you use a straight-line depreciation method for state tax purposes, which spreads the deduction evenly over the property’s useful life.
Real-Life Example: Balancing Federal and State Tax Benefits
Consider a real-life scenario involving a couple living in California where one spouse is a physician earning a high income and the other qualifies as a real estate professional. In their first year of investing, they acquired over 20 apartment units. By using accelerated depreciation on these properties, they sheltered a significant portion of their W-2 income from federal taxes—saving hundreds of thousands of dollars. However, when it came to their California state taxes, they did not receive the same benefit. They still paid state income taxes on their salary because California does not allow accelerated depreciation or recognize REPS for state tax purposes.
If You Live In California, Is it Worth It to Claim REPS?
While California’s tax rules limit the use of REPS and accelerated depreciation for state tax purposes, the ability to shelter federal income is still a powerful tool for real estate investors residing in California. By planning strategically, you can still leverage significant tax savings, even if California imposes additional restrictions. For more details on how to navigate these complexities, consider consulting with a tax professional who specializes in real estate to ensure you’re optimizing your tax strategy both federally and at the state level. Click here if you want a referral to our preferred real estate CPAs.
