In the 80’s and 90’s Congress amended the Internal Revenue Code (I.R.C.) to curb widespread abuse of tax loopholes. I.R.C. § 469 states that “taxpayers could not reduce the taxable portion of their true income with investment losses unless they materially participated in the investment”. Congress later went on to define material participation as “regular, continuous, and substantial participation”. In 1993 Congress decided that this definition was too stringent and unfair to a certain class of people. This class of people were real estate professionals who used their knowledge of the housing market to purchase rental properties. Congress enacted an exception that allowed professionals in this area to use their skills to acquire the property, and regardless of maintain material participation, offset his losses from the rental property activities against the nonrental real estate activities.
The case at bar is defining the exception stated above and whether I.R.C. §469(c)(7) automatically qualifies a real estate professional’s rental losses nonpassive and deductible.
Delores and Charles Gragg sought to deduct $38,152 in losses from their rental properties on their 2007 joint tax return. Delores is a licensed real estate agent who worked for a real estate broker during this time. During a 2009 audit of the Gragg’s tax return the IRS disallowed the rental losses because the IRS concluded that the Gragg’s had failed to show they materially participated in the rental properties.
The Gragg’s argue that Section 469(c)(2) “Passive activity includes any rental activity. Except as provided in paragraph (7), the term “passive activity” includes any rental activity” Id. in conjunction with 469(c)(7)(A) “If this paragraph applies to any taxpayer for a taxable year … paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year qualify a real estate professional for the provision and automatically rendered nonpassive and deductible.” Id.
The Court rejected this argument and held that “though 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.” Id.
In conclusion, real estate professionals are not exempt from the requirement of materially participating in rental property activities in order to deduct rental losses.
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