Under current tax law, losses from rental real estate activities are generally considered passive losses by statute. This means these losses are therefore only deductible against other sources of passive activity income, regardless of participation by the taxpayer. However, Code Section 469(c)(7) creates an exception to that rule, providing that taxpayers who qualify as ‘real estate professionals’ are not subject to the per se passive treatment for their rental activities. This exception allows for a real estate professional to treat rental losses as non-passive and deduct the losses against other sources of income (example: wages) if they “materially participate” in the rental activity.
A taxpayer, Delores Gragg, challenged the IRS in court on this issue, claiming that a real estate professional automatically received non-passive treatment to their losses and does not have to prove material participation for each rental activity.
In Gragg v U.S., the taxpayer worked as a licensed real estate agent. The taxpayer and her husband also owned two real estate rental properties. These rental properties generated losses that the taxpayers deducted on their federal tax return.
The IRS agreed that Delores Gragg was a real estate professional, but asked her to show that she “materially participated” in her rental activities. She could not do so, for the simple reason that she kept no records documenting the hours devoted to her rental activities because of her status qualifying her as a real estate professional. As a result, the IRS disallowed the real estate losses deducted on the Graggs’ tax returns. The tax court agreed with the IRS and held in their favor. The taxpayer appealed the tax court’s decision.
After reviewing the case, the 9th Circuit Court of Appeals agreed with the tax court and held that even though the taxpayer was a real estate professional, she failed to take the additional steps of proving that she materially participated in her rental activities. As a result, her rental activities remained passive, even though she was a real estate professional.
W&G Observation: Qualifying as a real estate professional is only one step in the process. A real estate professional still needs to maintain accurate records to support their material participation in their rental activities to receive non-passive treatment. One option available to Ms. Gragg to receive non-passive treatment of her rental losses would have been to make an election to aggregate all of her real estate activities to treat them as one activity for purposes of the material participation tests. This would have allowed for her hours worked as a real estate agent to be considered in determining material participation of the rental activities, and therefore allow for their non-passive treatment.