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C.A.R. Realegal: Deducting Rental Losses
Ninth Circuit Clarifies That There Must be Material Participation by the Licensee
Real estate professionals must materially participate in their rental activities in order to deduct rental losses according to the Ninth Circuit Court of Appeals which interpreted Internal Revenue Code § 469 in Gragg v. United States of America; Internal Revenue Service, No.14-16053, August 4, 2016.
One of the taxpayers held a real estate license and claimed losses related to rental properties they owned. The IRS requested a log of the licensee's activities related to the properties and ultimately denied the deductions, concluding that, even though holding a real estate license, the taxpayers had to show they materially participated in the rental property activity. In this case, two undated one-page notes of activity submitted by the taxpayers were not sufficient for the IRS to allow the deduction.
This case explores the history of amendments to IRC § 469 that were added to the tax code in 1986 and barred the deductibility of "passive activity" losses. "Passive activity" generally includes rental activity; however, in 1993, § 469 was modified to provide an exception for real estate professionals for "any rental real estate activity for such year." The law treats each rental interest separately as to the taxpayer's material participation, unless the taxpayer makes an election during that tax year to treat all interests as a single real estate activity.
In this case, the taxpayers argued that the amendment to IRC § 469 meant that being a real estate professional rendered rental losses non-passive and thus deductible. The IRS argued that the amendment merely removed the per se treatment of the losses as passive for real estate professionals but the taxpayers still had to demonstrate material participation in the rental activity.
The court, briefly discussing two prior tax court cases that came to the same result, found that § 469's text and case law "all point in one direction" such that real estate professionals "must show material participation in rental activities before deducting rental losses."
Bottom line – Holding a real estate license does not automatically entitle you to deduct your rental losses. If you wish to deduct your rental losses, be active in the management of your rental activities and document, document, document. Consider whether you wish to file an election regarding multiple properties to be treated as a single activity; as with any tax questions, we recommend that you consult with an accountant or tax specialist.
Copyright ©2016 CALIFORNIA ASSOCIATION OF REALTORS®, republished with permission from the CALIFORNIA ASSOCIATION OF REALTORS®. Requests for republication should be submitted directly to the CALIFORNIA ASSOCIATION OF REALTORS®.
