This is for informational purposes only and should not be considered legal or accounting advice about income properties.
Over 50% of people in California hold a real estate license even though a good percentage of them do not practice. Many hold the license to qualify for tax deductions on income properties that they own. These taxpayers will likely be affected by a recent 9th Circuit court decision for the case Gragg v. United States of America; Internal Revenue Service, which has added clarity to tax laws involving the deduction of rental losses. This means that simply holding a real estate license is not enough to deduct rental property losses. The owner must be actively involved in the management of the property and this involvement must be well documented.
After Congress passed the Tax Reform Act of 1986, a supposed tax loophole involving the deduction of losses from “passive” investments was significantly limited. The law created the requirement that the taxpayer have regular, continuous, and substantial participation in these investments in order for them to be used to reduce the taxable portion of their true income.
However, in 1993, the Congressional Committee on the Budget deemed that these changes had gone too far. They enacted § 469(c)(7), a change to the Internal Revenue Code (IRC), that created an exception to the rule above for taxpayers in the real property business, i.e. real estate professionals. Now this case has decided the scope of that exemption.
The Graggs declared rental losses in 2006 and 2007 on their joint tax return, during which years Delores Gragg had worked as a licensed real estate agent for a brokerage. The IRS, in response to these loss declarations, requested evidence that the Graggs had materially participated in the rental properties. After receiving two undated one-page notes estimating the hours Delores had worked on the rental properties, the IRS determined that the Graggs did not show enough evidence that they had materially participated in order to qualify for the deduction. The Graggs brought the case to court, citing that Delores’s status as a real estate professional automatically qualified the rental losses as nonpassive, regardless of material participation.
The court filed in favor of the IRS, concluding that the text of IRC 469 does not support this interpretation:
“[T]hough taxpayers who qualify as real estate professionals are not subject to § 469(c)(2)’s per se rule that rental losses are passive, they still must show material participation in rental activities before deducting rental losses.”
For more details or to see if this applies to you, speak with a qualified accountant or tax specialist.