Real Estate Professional's Rentals Do Not Automatically Escape Passive Loss Limitations

Delores Gragg in 2006 and 2007 was a licensed real estate agent who had sufficient hours in the real estate activity to be treated as a real estate professional under IRC §469(c)(7).  Based on that qualification alone, she and her husband took the position that she should be allowed to be treated as materially participating in the rentals and thus all losses be allowed in full on their returns without regard to Section 469.

However the Ninth Circuit Court of Appeals, considering this “automatic material participation” argument for the first time, rejected this view in the case of Gragg v. United States, Case No. 14-16053, CA9 affirming a decision of the U.S. District Court of Northern California.

Section 469’s general definition of a passive activity is found at IRC §469(c)(1) which provides:

(c) Passive activity defined

For purposes of this section—

(1) In general

The term “passive activity” means any activity—

(A) which involves the conduct of any trade or business, and

(B) in which the taxpayer does not materially participate.

Congress added a special rule that applied to have all rental real estate treated as passive regardless of the taxpayer’s participation that it added at IRC §469(c)(2):

(2) Passive activity includes any rental activity

Except as provided in paragraph (7), the term “passive activity” includes any rental activity.

When the section was originally added in 1986 the first clause above (“Except as provided in paragraph (7)…”) was not contained in that provision.  However those in the real estate industry were able to convince Congress that someone who is a full time real estate professional has a different relationship to rentals than a non-real estate person.

Thus, Congress added a special rule at §469(c)(7) that created an exception to the “automaticallypassive” provision:

(7) Special rules for taxpayers in real property business

(A) In general

If this paragraph applies to any taxpayer for a taxable year—

(i) paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii) this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

(B) Taxpayers to whom paragraph applies

This paragraph shall apply to a taxpayer for a taxable year if—

(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii) such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h).

Delores argued that if she met the requirements of IRC §469(c)(7)(A) above, which she easily did with her hours as a real estate agent, all of her rentals would automatically qualify for material participation status regardless of her hours in the rental activities.

But the Ninth Circuit panel decided Delores was reading too much into the provision—all it did was remove the “automatically passive” treatment (which is what IRC §469(c)(2) provides) but did not touch the general requirement to show material participation in §469(c)(1).

The panel noted that while the Ninth Circuit had not previously looked at this issue, the Tax Court had previously considered and rejected this argument in the case of Perez v. Commissioner, TC Memo 2010-232.  Rather, the Tax Court had held that the taxpayer had to meet the “material participation” standard to claim her real estate losses.

As well, the panel notes that the regulations under §469 require a showing of material participation in the rental activities even when qualifying as a real estate professional:

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. [Reg. §1.469-9(e)(1)]

The regulations also go on to require the participation be established without combining the rentals with any other activity:

[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. [Reg. §1.469-e(3)(i)]

The panel concludes that Delores’s position cannot be reconciled with the law or regulations.

Doris attempted to argue that a decision in a different case (Argarwal v. Commissioner, TC Summary Opinion 2009-29) supported her position.  However, the panel found the case not on point, noting:

…[T]hey contend that Agarwal v. C.I.R., another Tax Court case, supports their cause. It does not. The issue in Agarwal was whether a real estate agent could qualify as a real estate professional under § 469(c)(7)(C), notwithstanding the text of the statute, which specified that it applied to brokerages. T.C. Summ. Op. 2009-29, 2009 WL 513391 at *3 (U.S. Tax Ct. 2009). The Graggs contend that Agarwal permits material participation to be calculated as a function of a taxpayer's combined real estate activities, effectively removing the requirement that the taxpayer independently show material participation with regard to rental activities. The court in Agarwal did not specify how it determined material participation, but it recognized that “the determination of whether the qualifying taxpayer materially participated . . . must be met with respect to each rental activity,” suggesting that it would not permit a taxpayer to combine rental and nonrental activities for purposes of calculating material participation. Id. at *4 & n.4. Agarwal provides no compelling reason to depart from the Tax Court's decision in Perez, nor have we found one.

Delores had apparently failed to raise the argument that she could meet the material participation tests for the rentals on their own at the trial court level and, in any event, the Court noted that Delores’s records of her hours with the rentals provided at exam consisted of “two undated one-page notes estimating the hours Delores spent working on the Graggs' rental properties in 2006.”  That level of documentation would have been unlikely to be seen as convincing by the Court even for 2006 alone.

Advisers with clients who are real estate professionals should be sure to discuss the documentation of material participation in the rental activities standing alone with clients who are real estate professionals.  As well, strong consideration should be given to making the election to group all rentals as one activity under IRC §469(c)(7)(A) since such a grouping may be necessary to accumulate the necessary hours to show material participation, as well as potentially allowing losses for specific rentals where the taxpayer’s level of involvement is minimal.