Ninth Circuit Holds That Real Estate Professionals May Deduct Rental Losses From Their Taxable Income
Only If They Materially Participate In Rental Activities
In Gragg v. United States, et al., Delores and Charles Gragg asked the United States Court of Appeals for the Ninth Circuit to determine the circumstances in which real estate professionals may deduct investment rental property losses from their taxable income.
In 1986, Congress passed the Tax Reform Act of 1986 (“Act”) (codified at Internal Revenue Code section 469), in an effort to curb taxpayers’ deductions of losses from “passive” investments. Specifically, Congress implemented a rule whereby taxpayers could not reduce their taxable income with investment losses unless they materially participated in the investment. However, the Act treated investments in rental properties differently, and made any losses related to investment rentals per se passive, and therefore, per se nondeductible. In 1993, believing that the Act had gone “too far,” Congress enacted Section 469(c)(7), which created an exception to the per se bar on rental loss deductions, to wit: the per se rental bar “shall not apply” to taxpayers who qualify as real estate professionals.
Pursuant to Section 469(c)(7), the Graggs sought to deduct rental losses they incurred in 2006 and 2007 from their taxable income. Delores is a licensed real estate agent who worked for a real estate brokerage during both years. On their 2006 joint tax return, the Graggs deducted $38,153 in losses from rental properties they owned. On their 2007 return, they deducted $40,390 in rental losses. The Internal Revenue Service (“IRS”) audited the Graggs in 2009, and requested a “written log of all…rental related activities that w[ould] support the deduction claimed.” The Graggs submitted two (2) undated one-page notes estimating the hours Dolores spent working on the Graggs’ rental properties in 2006. However, the IRS disallowed the rental loss deductions, finding that the Graggs were required to show they materially participated in the rental properties, and that the two (2) undated notes failed to satisfy the material participation requirement.
The Graggs filed suit in the United States District Court for the Northern District of California, asserting that by virtue of Delores’s status as a real estate professional, the Graggs’ rental losses were automatically nonpassive, and that they did not need to prove that they materially participated in the rental properties. However, the District Court disagreed, finding that the Graggs were required to prove material participation, and disallowed the rental loss deductions. The Graggs appealed to the Ninth Circuit.
The Ninth Circuit determined the issue on appeal to be whether Section 469(c)(7) automatically renders a real estate professional’s rental losses nonpassive and deductible, or whether it merely removes the per se bar on treating rental losses as passive. The Ninth Circuit affirmed the District Court’s ruling, finding that “Section 469’s text, regulations, and relevant case law all point in one direction: though taxpayers who qualify as real estate professionals are not subject to [section] 469(c)(2)’s per se rule that rental losses are passive, they must still show material participation in rental activities before deducting rental losses.” Therefore, the Graggs could not deduct their rental losses absent material participation.
(The Graggs did not argue in the District Court that the two (2) undated one-page notes estimating the hours Delores spent working on the rental properties satisfied the material participation requirement, and therefore, the Ninth Circuit did not address this issue on appeal.)
Nick D. Fine, Associate, firstname.lastname@example.org