In the recently decided case of Gragg v. United States, 118 AFTR 2d 2016-5091 (9th Cir. 2016), the U.S. Court of Appeals for the Ninth Circuit held that a taxpayer's activities as a real estate professional were insufficient to show material participation for purposes of her claimed losses from rental real estate.
The taxpayers, a husband and wife, owned a number of rental real estate properties that generated losses. The IRS determined that the taxpayers could not use these losses to offset other income because the taxpayers' rental real estate activity was passive. The taxpayers contended that they had satisfied the material participation standard by virtue of taxpayer-wife's occupation as a real estate agent. In Gragg, et al. v. United States et al, 113 AFTR 2d 2014-1647; No. 12-CV-03813 YGR (N.D. Cal. Mar. 31, 2014), the U.S. District Court for the Northern District of California rejected the taxpayers' position.
Passive losses can only be used to offset passive income. Whether an activity is active or passive depends on whether the taxpayer materially participates in the conduct of the activity. Generally, rental activities are considered per se passive activities and may not be used to offset non-passive income. However, this "per se" rule does not apply to taxpayers who are real estate professionals. A taxpayer is a real estate professional if: (1) more than half of the personal services he performs are in real property businesses in which he materially participates; or (2) he performs more than 750 hours of services in real property business in which he materially participates.
The Ninth Circuit upheld the decision of the District Court. While the taxpayer's activities as a real estate professional allowed the taxpayers to avoid application of the per se rule, the taxpayers still needed to show that they materially participated in rental real estate activity. To recharacterize the rental real estate losses as non-passive, the taxpayers were required to show that they materially participated in separate and distinct rental real estate activity. Because the taxpayers failed to meet this burden, the Court upheld the IRS' decision denying a refund.
Real estate professionals who otherwise engage in rental real estate activity should be aware that professional activities alone are insufficient to recharacterize rental real estate activity as non-passive. Such professionals also must show that they materially participated in the separate activity and should keep records and logs sufficient to establish their distinct participation in those activities in order to avoid the passive activity loss limitations.
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