August 7, 2016

Real Estate Professionals Subject to Material Participation Rules

Houston Tax Attorney Blog

Houston Tax Attorney

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But can you be a real estate professional for the passive activity loss rules and then have your passive losses denied under the material participation rules?  The Gragg v. United States, No. 14-16053 (9th Cir. 2016) case presents an opportunity to consider this fact pattern.

The Facts & Procedural History

The taxpayer was a real estate agent that owned rental properties. The rental properties produced tax losses.  The IRS audited his return and disallowed his rental losses.

The taxpayer qualified as a real estate professional as defined in the passive activity loss rules, as he was able to aggregate his rental and real estate sales activities in qualifying as a real estate professional.  The court accepted this conclusion.  These rules allow a taxpayer to sidestep the passive activity loss rules.

The case addresses whether a real estate professional’s losses are limited by the material participation rules.  To understand the case, we need to consider the rules closer.

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.

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:

  1. 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
  2. More than 750 hours of services during the tax year were in real property trades or businesses in which he materially participated.

This real estate professional exception creates a high hurdle.

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.

If these rules are met, expenses for a rental property are immediately deductible.

Do Both Sets of Rules Apply?

This brings us back to the Gragg case.  The taxpayer argued that the material participation rules did not apply, given that he satisfied the real estate professional rules.  The court did not address this issue as it was not raised at the trial court level.

On first pass, it would seem that if the taxpayer met the 750 hours to be a real estate professional, he would also meet the 500 hours to materially participate.

The problem the taxpayer 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 the taxpayer 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 takeaway from this case 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.  This documentation would identify hours associated with the real estate, rather than the additional hours as a real estate agent unrelated to the real estate.

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