In the January/February 2017 edition of the Journal of Corporate Taxation, the topic of Section 469 Loss Limitation Rules is broached. The simple truth is that many real estate professionals have questions regarding the losses they can deduct due to their real estate activities. In fact, for many real estate professionals, the ability to deduct certain losses can make the difference between facing a large tax liability and having no taxes due or receiving a tax refund.
There are tax rules that constrain an individual’s ability to treat rental losses as active rather than passive losses. As such, it may be inappropriate for certain individuals to claim rental losses when they file their taxes as allowable passive losses are ordinarily limited to the amount of passive income over a particular tax year. However, there are certain provisions that can allow real estate professionals to claim these by definition passive losses provided that they Materially Participate in the rental real estate avoid the general Section 469 restrictions on passive losses. This blog post will delve further into some of the mechanics that real estate professionals should familiar themselves with prior to deducting qualifying rental losses against their ordinary “active” sources of income.
The Graggs were husband and wife taxpayers who filed their 2006 joint income tax return deducted certain real estate losses from properties they owned. The Graggs took this tax position despite Section 469 of the U.S. Tax Code which generally prohibits taxpayers from claiming deductions against income from certain passive investments including real estate investments. However, in 1993, Congress amended the law by adding Section 469(c)(7) which specifically overturned the prohibition against deducting passive rental losses. The Gragg’s deducted $38,153 in real estate losses in 2006 and $40,390 in rental losses in 2007 claiming they were real estate professionals.
A deduction of rental losses can be supported only when certain factors and circumstances are present. Generally, this means that the claimed loss must be non-passive in nature. Section 469(c)(1) sets forth that the term “passive activity” is defined as any transaction or action involving the conduct of trade or business where the taxpayer does not materially participate. For most individuals, the effect of Section 469(c)(2) making “any rental activity” a ”passive activity” means that most people will not be able to claim real estate rental losses unless they qualify as real estate professionals and activity participate in the rental real estate activity.
Section 469(c)(7) sets forth a special rule that exempts “taxpayers in real property business” (real estate professionals) from the application of Section(c)(2) which would otherwise make the losses passive and non-deductible. Essentially, Section(c)(7) eliminates that per se presumption that real estate activities are automatically passive in nature. Rather, real estate professionals are not automatically barred from claiming this loss. However, due to the general rule set forth under Section 469(c)(1) disallowing passive activity deductions, a real estate professional taxpayer must still show that activities were not passive through material participation and must be able to prove that they materially participated if their status as real estate professionals is challenged by the IRS.
In Gragg, the taxpayers submitted proof that Dolores Gragg was a real estate professional. The IRS did not challenge this characterization. However, the IRS disallowed the Gragg’s real estate deductions on the basis that the taxpayers had failed to present any evidence that the taxpayers had materially participated. The Graggs countered this view on the basis that Dolores’ unchallenged status as a real estate professional resulted in per se characterization of real estate activities as non-passive. The court disagreed.
The court found that Section 469(c)(7) does exempt qualifying taxpayers from the presumption set forth in Section 469(c)(2). However, Section 469(c)(7) does not also result in a per se characterization of material participation in the losses. Rather, the taxpayer claiming the deduction must still present sufficient evidence showing that the losses were not passive and that their properly documented rental activity meets the material participation requirement.
Real estate professionals are generally well-served by deducting their allowable real estate and rental losses. However, a failure to consider the requirements that must be met to properly claim this type of tax deduction can result in disallowed rental real estate losses when faced with an audit, leading to additional tax liabilities along with potential penalties and interest. If the service were to require all prior tax years where real estate professional status was improperly claimed the financial setback could be catastrophic. Working with a tax lawyer can increase the likelihood that your tax positions are well-supported reducing the odds that the IRS adjusts your taxes or launches an audit. If you are facing an audit involving your real estate professional status hiring a tax lawyer can make all the difference in either sustaining the ability to claim real estate professional status or where it was claimed improperly doing damage control. To schedule a reduced-rate consultation with tax attorneys and CPAs with law offices in Los Angeles and Orange County, call 800-681-1295 today.