Are you a real estate professional? Do you work over 750 hours a year on real estate activities and are these annual hours over half the time you work in total?
If so, you can offset real estate losses against your ordinary, taxable income. If one spouse is a doctor and the other is a real estate professional, any passive real estate losses can be used to offset the doctor’s ordinary income.
It is a great tax saving strategy.
Which is why the IRS is careful in its scrutiny of such offsets. A recent case further defines the requirements for doing it right. While the discussion below is somewhat technical, you may want to understand the important points.
This applies to you if:
- You own and manage rental property, or
- You are a professional in real estate and,
- Half your hours (a minimum of 750) are dedicated to real estate activities,
- You have rental property losses that you would like to deduct, and,
- You have documented logs of rental activities and other substantiating evidence.
If all of the above are true, then you can deduct the losses against your ordinary, taxable income.
For details of the case and the court findings (which may be somewhat technical) read on.
The United States Court of Appeals, Gragg v. United States, 2016 WL 4136982 (9th Cir., Aug. 4, 2016) for the Ninth Circuit was required to determine the scope of 26 U.S.C. §469 with respect to “real estate professionals.” Specifically, the Ninth Circuit was required to determine whether 26 U.S.C. §469 entitles real estate professionals to deduct rental losses without showing material participation in the rental property. The court held that real estate professionals are allowed to deduct rental losses from their taxable income only if they materially participate in rental activities. (2016 WL 4136982, at *1.)
In Gragg, married taxpayers, Delores and Charles Gragg (the “Graggs”), sought to deduct from their taxable income rental losses they incurred from rental properties they owned. Delores was a licensed real estate agent who worked for a real estate brokerage. The issue on appeal was whether 26 U.S.C. §469(c)(7) automatically rendered a real estate professional’s rental losses nonpassive and deductible, or whether it merely removed 26 U.S.C. §469(c)(2)’s per se bar on treating rental losses as passive. The Ninth Circuit concluded that 26 U.S.C. §469(c)(7) did not automatically render a real estate professional’s rental losses nonpassive and deductible, and that 26 U.S.C. §469(c)(7) merely removed 26 U.S.C. §469(c)(2)’s per se bar on treating rental losses as passive. 2016 WL 4136982, at *2.
The Ninth Circuit found support for its decision in Treasury Regulation 1.469-9(e)(1) and the prior Tax Court decision in Perez v. C.I.R., 100 T.C.M. (CCH) 351, at *1 (2010). 2016 WL 4136982, at *3.
The operative provisions of Section 469 may be paraphrased, as follows:
- Section 469(c)(1) provides that all activities in which a taxpayer does not materially participate are passive.
- Section 469(c)(2) provides that all rental activities are passive, irrespective of how much a taxpayer participates.
- Section 469(c)(7) provides that, if a taxpayer qualifies as a real estate professional, then Section 469(c)(2) does not apply.
Significantly, Section 469(c)(7) does not provide that, if a taxpayer qualifies as a real estate profession, then Section 469(c)(1) does not apply. Thus, even if a taxpayer qualifies as a real estate professional, the taxpayer still must show material participation in rental activities in order to avoid classification of rental activities as passive. Stated in other words, even if a taxpayer qualifies as a real estate professional, rental activities are not thereby automatically deemed to be nonpassive. This is the proposition that the Graggs argued and lost before the Ninth Circuit. The Graggs plainly were wrong.
Real estate professionals are allowed to deduct rental losses from their taxable income only if they materially participate in rental activities. To prove participation it is strongly suggested you keep a log and other supporting evidence of your real estate activities.
Treasury Regulation 1.469-9(e)(1) provides that a taxpayer who qualifies as a real estate professional can treat rental losses as nonpassive, but only so long as she materially participates:
“Section 469(c)(2) [the per se rental bar] does not apply to any rental real estate activity of a taxpayer for a taxable year in which the taxpayer is a qualifying taxpayer under paragraph (c) of this section [i.e., a real estate professional]. Instead, a rental real estate activity of a [real estate professional] is a passive activity under section 469 for the taxable year unless the taxpayer materially participates in the activity.” (Emphasis added.)
Likewise, Treasury Regulation 1.469-9(e)(3)(1) confirms that even taxpayers who establish real estate professional status must separately show material participation in rental activities (as opposed to other real estate activities) before claiming any rental losses as nonpassive:
“[I]f a qualifying taxpayer develops real property, constructs buildings, and owns an interest in rental real estate, the taxpayer’s interest in rental real estate may not be grouped with the taxpayer’s development activity or construction activity. Thus, only the participation of the taxpayer with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity under [the material participation safe harbor provisions in] § 1.469–5T.” (Emphasis added.)
In Perez, supra, 100 T.C.M. (CCH) 351, at *2, the taxpayer argued, as did the Graggs, that because she was a qualifying real estate professional pursuant to section 469(c)(7)(B), all of her real estate activities, including rental activities, were not passive, and, therefore, she was not subject to the passive activity loss limitations. The Tax Court disagreed, ruling that “[c]aselaw clearly requires that a taxpayer claiming deductions for rental real estate losses meet the ‘material participation’ requirement.”