August 14, 2014
By Mariana Moghadam, CPA
Over the past year, qualifying as a real estate professional has become more important, and even more difficult than it ever was in the past. Since 1994, the issue has been significant, mainly to those taxpayers (including many of our clients) who have rental real estate losses that they want to offset against their earned or active or investment income.
However, beginning in 2013, being treated as a qualified real estate professional has also become critical for those individuals with rental real estate gains. After all, if the income from rental real estate (including any gains from the sale of property) is considered non-passive under IRC sec. 469, then that income is not going to be subject to the new 3.8% tax on net investment income.
Since 1986, most rental activities are “per se” considered passive. Because this imposes a hardship on real estate professionals, an exception to the rule was carved out for those real estate professionals who meet the criteria of IRC sec. 469(c)(7):
- More than one-half of the taxpayer’s personal services are performed in real property trades or businesses in which he or she materially participates; AND
- The taxpayer works more than 750 hours in real property trades or businesses in which he or she materially participates.
In other words, the rental real estate activities will continue to be treated as passive gains and losses, unless the taxpayer materially participates in each of those rental real estate activities.
The Gragg Case
A recent court decision in California, involving husband-and-wife taxpayers, Charles and Delores Gragg, illustrates some of the hurdles in receiving the tax status of qualified real estate professionals [Gragg v. U.S., 113 AFTR 2d 2014-XXXX (N.D. Cal.)].
The Graggs owned two real estate rental properties that incurred losses in 2006 and 2007. In jointly-filed returns, the Graggs deducted those losses from their otherwise taxable income. After all, Mrs. Gragg’s full-time occupation as a real estate professional should have entitled the couple to offset their earned income with losses from rental real estate activities.
The IRS did not dispute the fact that Mrs. Gragg was a qualified real estate professional in both 2006 and 2007. However, the Service disallowed the losses based on the fact that Mrs. Gragg did not materially participate in the particular rental activities that generated those rental losses. As a result, the District Court for the Northern District of California agreed with the IRS, concluding that Mrs. Gragg’s work as a real estate agent and her ownership of rental real estate were separate and distinct activities that cannot be considered together.The Hurdles
It is not surprising that the IRS audited the Graggs’ returns. In recent years, the Service has a track record of examining the returns of would-be qualified real estate professionals.
In this case (like so many others), Mrs. Gragg provided the court with her estimates of the amount of time she spent on the couples’ rental activities. Since the hours she spent on the rental activities were “overall” estimates rather than contemporaneous time logs and calendars, the court agreed with the IRS that Mrs. Gragg’s estimates were not a “reasonable means” of documenting her material participation in the rental activities.
Adding Insult to Injury
Even if Mrs. Gragg’s participation in the rental activities had exceeded 750 hours in a year, the Graggs would have been required to make a “grouping” election under IRC sec. 469(c)(7)(A)(ii) to treat the two separate real estate rental properties as one “activity.” As a result, the court held that the two rental properties should be treated as separate activities for tax purposes.
The Bottom Line
With situations like the Graggs, it has become commonplace for the IRS to disallow the deduction of real estate rental losses. Court decisions in the past several years have upheld the Service’s insistence on contemporaneous substantiation to prove material participation in real estate rental activities.
As a result, those taxpayers who are considering treating their rental losses (or, in 2013 and forward, their rental gains) as non-passive should be certain they have appropriate records and, if necessary, have made a grouping election. As always, it makes sense to discuss these situations with your tax advisor prior to filing any tax return involving real estate rental activities.