An important passive activity loss rules case

A recent court case serves as a good reminder of how the passive activity loss (PAL) rules apply to real estate professionals.

The case

In the case Gragg v. United States, US District Court, N.D. Calif., 2014-1 U.S.T.C. para. 50,245 (March 31, 2014), the taxpayer was a professional real estate agent and in her personal capacity owned two real estate rental properties. The taxpayer sustained losses with respect to her two rental properties, and sought to deduct the losses from otherwise taxable income (i.e., treated them as non-passive). The taxpayer based her position on a theory that she could attribute her involvement as a real estate professional to her personal rental real estate activities, resulting in satisfaction of the material participation requirement.

The court dismissed the taxpayer’s basis for claiming she materially participated in her rental real estate activities by reference to Reg. Sec. 1.469-9(e)(3). That regulation provides that a qualifying taxpayer cannot group a rental real estate activity with any other type of real estate activity of the taxpayer. That is, for purposes of determining material participation, real estate rental activities stand alone, regardless of a taxpayer’s involvement in other types of real estate activities, such as real estate development for real estate agent services. Accordingly, the court held since grouping real estate agent activities with rental property activities would have been the only way to satisfy ‘material participation’ for the taxpayer, the losses were not appropriately characterized as non-passive activity losses, and thus were disallowed for the years taken.

Observation

The proper determination of a trade or business activity’s status as passive versus non-passive has become increasingly critical, as such characterization also influences whether the activity’s income is subject to the new 3.8 percent Net Investment Income (NII) tax. The rules with respect to rental real estate can be especially complex since the rental activity must also independently satisfy the “trade or business” requirement, for purposes of the NII tax. Thus, anyone engaged in real estate activities, especially where there are activity dispositions or additions, should carefully assess new groupings and grouping additions, as well as documentation of material participation and the delineation between time spent as a real estate agent versus time spent in the context of real estate rental activities.

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