In Gragg, et al. v. USA; IRS Commissioner (2016), a three-judge panel of the Ninth Circuit Court of Appeals affirmed the Northern District Court of California’s ruling that plaintiffs Charles and Delores Gragg, the latter of whom is a California DRE-licensed salesperson in Pleasanton and was engaged as a real estate professional during tax years 2006 and 2007, could deduct from taxable income passive activity rental property losses where there was an insufficient showing of her material participation in the rental activity. Specifically, the panel was asked to determine whether Internal Revenue Code section 469 “entitles real estate professionals like petitioner Delores Gragg to deduct rental losses without showing material participation in the rental property.”
The Graggs’ joint return was audited in 2009 and the deduction of $38,153.00 in rental losses disallowed.
IRC section 469, entitled “Passive Activity Losses and Credits Limited,” generally prevents rental losses from being deducted from taxable income. Here’s the relevant subsection language in IRC section 469, from which the Graggs decided their eligibility for the deduction from taxable income for rental losses:
(1) In general If for any taxable year the taxpayer is described in paragraph (2), neither –
(A) the passive activity loss, nor
(B) the passive activity credit, for the taxable year shall be allowed.
(2) Persons described The following are described in this paragraph:
(A) any individual . . .
(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.
(2) Passive activity includes any rental activity Except as provided in paragraph (7), the term “passive activity” includes any rental activity [“the per se rental bar”]. . . .
(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. . . .(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.
The Graggs argued that IRC section 469(c)(7) provides an automatic exception to passive activity for “rental real estate activity” whether or not they materially participated. I think they had a strong argument (at least from the four corners of the statute) that Delores Gragg, as a real estate professional under IRC section 469(c)(7)(B), qualified for the rental real estate activity exception to “passive activity” as defined under IRC section 469(c)(1).
While the Ninth Circuit had never decided this issue, the panel held the Graggs must show material participation as required under IRC section 469(c)(1). What’s more, the U.S. Tax Court provided persuasive authority which “squarely rejected” the Graggs’ opinion. In Perez v. C.I.R. (2010), “the taxpayer argued, as the Graggs do here, that ‘because she [was] a qualifying real estate professional pursuant to section 469(c)(7)(B), all her real estate activities, including rental activities, [were] not passive and therefore she [was] not subject to the passive activity loss limitations.’ [citation] The Tax Court disagreed, ruling that ‘[c]aselaw clearly requires that a taxpayer claiming deductions for rental real estate losses meet the “material participation” requirement.’”
Additionally, “the IRS Treasury Regulations implementing § 469 reinforce this interpretation. Treasury Regulation § 1.469-9(e)(1) states that a taxpayer who qualifies as a real estate professional can treat rental losses as nonpassive, but only so long as she materially participates: 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.”
Hindsight is 20/20, and while the plaintiffs’ position in this case has merit based on the less than clear language in IRC section 469, the opinions cited by the Ninth Circuit panel reflect that the plaintiffs had an uphill battle from the starting line. Unless they request the entire Ninth Circuit Court of Appeals reconsider this opinion and (assuming they’re unsuccessful there) receive a favorable outcome from SCOTUS, the Graggs will lose the $38,153.00 in deductions they’ve taken, and incur emotional stress and likely far worse substantial attorney fees and costs, which would seem to make the exercise fall short of good business judgment. That said, I salute their spirit in testing the statute. I’ll be the first to congratulate them if they succeed. Nobody likes to pay tax.