Rental Losses Not Automatically Nonpassive Due To Status As Real Estate Professional

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HKA has always believed that you must materially participate in a rental activity even if you hold a realtor license.  Court affirms the stance.

The Court of Appeals for the Ninth Circuit has found that a taxpayer’s rental losses were not automatically nonpassive because of her status as a real estate professional. The court rejected the taxpayer’s argument that she did not need to show material participation in the rental property.

Take away. The Ninth Circuit noted that the Tax Court has held that caselaw clearly requires that a taxpayer claiming deductions for rental real estate losses must meet the material participation’ requirement.

Background

The taxpayer worked as a licensed real estate agent. The taxpayer deducted losses from rental properties she owned on her 2006 and 2007 returns. The IRS disallowed the rental losses. The IRS determined that the taxpayer had failed to show she materially participated in the rental properties. The taxpayer countered that her status as a real estate professional made her rental losses per se nonpassive. A federal district court ruled against the taxpayer and she appealed to the Ninth Circuit.

Court’s analysis

The court first found that Code Sec. 469(c)(1) provides the general rule that any activity in which a taxpayer does not materially participate is passive. The term “passive activity” means any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. Further, Code Sec. 469(c)(2) establishes that rental activity is per se passive, regardless of whether the taxpayer materially participates; however, Code Sec. 469(c)(7) provides an exception for real estate professionals. Reg. §1.469-9(e)(1) provides that a real estate professional can treat rental losses as nonpassive, but only so long as he or she materially participates.

A taxpayer performs qualifying services in real property businesses if: (1) More than half of the personal services performed in a trade or business by the taxpayer are performed in real property businesses in which the taxpayer materially participates; and (2) The taxpayer performs more than 750 hours of services during the tax year in real property businesses in which the taxpayer materially participates. A taxpayer who meets the preceding requirements is commonly referred to as a real estate professional for purposes of the passive loss rules.

Compliance Alert

The court noted that the exception to the passive loss rules for rental activities of taxpayers who are involved in a real property business applies for tax years beginning after December 31, 1993.

The court found that even taxpayers who establish real estate professional status must separately show material participation in rental activities (as opposed to other real estate activities) before claiming any rental losses as nonpassive. Only the participation of the taxpayer with respect to the rental real estate may be used to determine if the taxpayer materially participates in the rental real estate activity under the material participation safe harbor provisions. Taxpayers who qualify as real estate professionals still must show material participation in rental activities before deducting rental losses, the court concluded.

Compliance Pointer

The court declined to address the taxpayer’s new argument that undated notes estimating the total hours spent on rental properties satisfied the burden of showing material participation.

If you have any questions or would like to discuss this further, please do not hesitate to give us a call at our office, 314-993-4285.

This information was received from CCH Federal Tax Weekly, Issue No. 33.

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