New guidance on real estate professional losses
Real estate professionals must materially participate to deduct losses
TAX ALERT |
In a recent decision (Gragg v. U.S.), the 9th U.S. Circuit Court of Appeals held that a qualified real estate professional must materially participate in a rental real estate activity to deduct losses from that activity. This ran contrary to the taxpayers’ contention that, because Mrs. Gragg qualified as a real estate professional, the material participation requirement was waived or deemed satisfied.
Generally, individual taxpayers must materially participate in a business activity to be able to deduct net losses from that activity. An activity in which a taxpayer does not materially participate is said to be a passive activity with respect to that taxpayer. Under a special rule, rental activities are treated as per se passive activities without regard to material participation, unless a taxpayer qualifies as a real estate professional.
In the case before the 9th Circuit, the parties did not contest whether or not Mrs. Gragg qualified as a real estate professional. The court, however, rejected the Graggs’ claim that they did not need to prove material participation in the rental activity due to Mrs. Gragg’s status as a real estate professional. Citing various statutory, regulatory and judicial authority, the court concluded that being a real estate professional only relieves the taxpayer from per se passive activity treatment for rental activities, and not the otherwise applicable material participation rules. Although the Graggs also attempted to show, as an alternative argument, that Mrs. Gragg did materially participate in the rental activity, the court rejected this contention as it was not raised before the lower court.