Real estate professional status didn’t make rental losses automatically deductible !!
Gragg vs. U.S., (CA 9 8/4/2016) 118 AFTR 2d ¶ 2016-5091
The Court of Appeals for the Ninth Circuit, affirming the district court, has held that for purposes of the passive activity loss (PAL) rules, the taxpayer’s status as a real estate professional under Code Sec. 469(c)(7) did not make her rental losses automatically nonpassive. She still had to prove material participation in her real estate rental activities in order to deduct those losses from her nonpassive income.
Background on PAL rules. In general, under the PAL rules of Code Sec. 469, losses from passive activities may only be used to offset passive activity income. Code Sec. 469(c)(1) provides that a “passive activity” is any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. A taxpayer is treated as materially participating in an activity if he meets at least one of the seven tests in Reg. § 1.469-5T. For example, under one of these tests, an individual will be treated as materially participating in an activity for a tax year if the individual participates in the activity for more than 500 hours during such year. (Reg. § 1.469-5T(a)(1))
In general, under Code Sec. 469(c)(2), a rental activity is per se a passive activity regardless of the taxpayer’s participation in the activity. However, under Code Sec. 469(c)(7), the per se rule for rental activities doesn’t apply to a qualifying real estate professional. A taxpayer qualifies as such for a particular tax year if:
- More than half of the personal services that he performs during that year are performed in real property trades or businesses in which he materially participates; and
- He performs more than 750 hours of services during that tax year in real property trades or businesses in which he materially participates. (Code Sec. 469(c)(7)(B))
Reg. § 1.469-9(e)(1) states that a taxpayer who qualifies as a real estate professional can treat rental losses as nonpassive, but only if he materially participates. Specifically, the reg provides:
Code Sec. 469(c)(2) [i.e., 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 qualifying taxpayer [real estate professional] is a passive activity under Code Sec. 469 for the taxable year unless the taxpayer materially participates in the activity.
In addition, Reg. § 1.469-9(e)(3)(i) 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.
In Perez, (2010) TC Memo 2010-232TC Memo 2010-232, a taxpayer argued that because she qualified as a real estate professional based on her job as a real estate loan agent and broker, and not solely by virtue of her ownership of rental real estate, she wasn’t required to pass the material participation test to claim her rental losses. The Tax Court rejected the taxpayer’s position and agreed with IRS that, based on Reg. § 1.469-9(e)(1)’s plain language, while the rental activities of a professional aren’t per se passive, they are subject to the regular material participation rules—which the taxpayer failed to satisfy.
Facts. During the 2006 and 2007 tax years, Charles and Delores Gragg, husband and wife, owned two real estate rental properties. Mr. Gragg was employed as a vice president of logistics, and Mrs. Gragg’s occupation was in real estate sales, i.e., a full-time licensed real estate agent. Their rental properties incurred losses for those years, and they deducted those losses from their taxable income on their joint return.
On audit, IRS disallowed the rental losses because it determined that the Graggs were required to show that they materially participated in their rental properties and had not done so.
The Graggs paid the deficiencies and filed refund claims with IRS for both years, which were denied. They sought relief in the district court.
District court decision. The district court granted IRS summary judgment in the refund suit, rejecting the taxpayers’ contention that Delores’s status as a real estate professional rendered their rental losses per se nonpassive. The court held that the tacxpayers weren’t excused by the wife’s Code Sec. 469(c)(7) real estate professional status from having to prove material participation in each real estate activity before deducting otherwise passive losses. This she failed to do, offering only noncontemporaneous “ballpark guesstimates” of time she spent on these activities. (Gragg v. U.S., (DC CA 3/31/2014) 113 AFTR 2d 2014-1647113 AFTR 2d 2014-1647)
The issue. On appeal, the issue was whether Code Sec. 469(c)(7) automatically renders a real estate professional’s rental losses nonpassive and deductible, or whether it merely removes Code Sec. 469(c)(2)’s per se bar on treating rental losses as passive. The Graggs argued for the former interpretation, and IRS argued for the latter.
Appellate court decision. The Ninth Circuit found that Code Sec. 469’s text, its regs, and the relevant case law all pointed to one conclusion: though taxpayers who qualify as real estate professionals are not subject to Code Sec. 469(c)(2)’s per se rule that rental losses are passive, they still must show material participation in rental activities before deducting rental losses.
The Court reasoned that the text of Code Sec. 469 favored IRS’s interpretation. The effect of the Code Sec. 469(c)(7) exception was merely that the per se bar didn’t apply. If the per se rental bar didn’t apply, the general rule under Code Sec. 469(c)(1) did, and the activity was passive unless the taxpayer materially participated. The regs (Reg. § 1.469-9(e)(1) and Reg. § 1.469-9(e)(3)(i)) supported this interpretation and couldn’t be reconciled with the Graggs’ understanding that the Code Sec. 469(c)(7) exception excused real estate professionals from the material participation requirement. While the Ninth Circuit had not previously addressed the Graggs’ interpretation of Code Sec. 469, the Tax Court—the opinions of which the Ninth Circuit viewed as persuasive authority—had squarely rejected the taxpayers’ argument in Perez.
The Court determined that Congress endeavored to narrow the scope of permissible deductions for passive losses in real estate investments, in part by requiring material participation before losses could be deducted. Real estate professionals were not exempted from this requirement.