Rules for Real Estate Professionals and Material Participation
Most individuals who invest in real estate to generate rental income hate the passive activity loss rules. These rules often prevent real estate investors from benefiting from the otherwise generous deductions that are associated with real estate. In Gragg v. United States, No. 14-16053, the Ninth Circuit Court of Appeals confirmed that real estate rental activities are subject to the passive activity loss rules and the material participation rules.
The Passive Activity Loss Rules
The passive activity loss rules generally say that passive activity losses can only offset passive activity income. Rental real estate activities are deemed to be passive. This prevents taxpayers from using losses from rental real estate activities to offset income from activities in which they materially participate.
The Material Participation Rules
The material participation rules look to whether an activity is carried on in a regular, continuous, and substantial basis. The regulations provide seven exclusive tests which indicate that the taxpayer materially participates in the activity. The individual only has to satisfy one of these tests to be found to materially participate in the activity. Several of these tests look at the time the individual participated in the activity. For example, one test asks whether the individual performed more than 500 hours on the activity during the year.
The Real Estate Professional Exception
There is an exception from the passive activity loss rules for real estate professionals. This exception allows real estate professionals to deduct real estate losses against non-passive income.
To qualify for the real estate professional exception, the individual must show that:
- More than one-half of his personal services in all trades or businesses for the tax year must be performed in real property trades or businesses in which he materially participated and
- More than 750 hours of services during the tax year were in real property trades or businesses in which he materially participated.
The Gragg Case
In Gragg, the taxpayer was a real estate agent that owned rental properties. The rental properties produced tax losses.
Gragg qualified as a real estate professional as defined in the rules given that he worked as a real estate agent. The court accepted this conclusion.
The taxpayer argued that once this exception was satisfied, the material participation rules did not apply. The court did not agree. It focused on the regulations and prior court cases that say that the material participation rules do apply.
Gragg did not have a backup plan at the outset. He argued that even if the material participation rules did apply, he would satisfy those rules as well. The appeals court did not consider this argument as Gragg did not raise the argument with the district court prior to the appeal.
It would seem that if Gragg met the 750 hours to be a real estate professional, he would also meet the 500 hours to materially participate.
The problem Gragg probably faced was that he did not work more than 500 hours on his rental real estate during the year. This is especially true if Gragg employed a property manager for the rentals. The material participation rules include a limitation whereby a taxpayer’s time managing rental property is disregarded if another manager performs more hours than the taxpayer in managing the real estate during the year.
The take away is that real estate professionals need to also document their material participation in their rental activities to be able to deduct tax losses associated with the rentals.