Not so fast! Federal court denies real estate agent's rental loss deduction

The IRS generally considers rental real estate investments as passive activities, meaning taxpayers can use any related losses only to offset income from passive investments. The tax code does grant an exception for rental activity losses incurred by real estate professionals, but it’s not enough just to qualify as a real estate professional. As the U.S. Court of Appeals for the Ninth Circuit recently ruled, you must also prove that you materially participated in the rental properties.

The taxpayer’s argument

A married couple deducted rental losses on their 2006 and 2007 federal income tax returns. The wife is a licensed real estate agent who worked for a real estate brokerage during those years.

The IRS audited their returns in 2009, and they submitted documents establishing that the wife was a “real estate professional” under the exception. The IRS requested a written log of all rental-related activities supporting the deductions, and the couple submitted two undated one-page notes estimating the hours the wife spent working on their rental properties in 2006.

Concluding that the couple failed to show they materially participated in the rental properties, the IRS disallowed the rental losses. After making the necessary payments, the couple sued for a refund.

They argued that the wife’s status as a real estate professional rendered their rental losses automatically nonpassive and therefore deductible, regardless of material participation. The district court dismissed the lawsuit before trial, and the couple appealed to the Ninth Circuit.

The court’s reasoning

The appellate court rejected the couple’s argument, finding that Internal Revenue Code Section 469(c)(7) didn’t support their interpretation. According to the court, the real estate professional exception is an exception only from the general rule that rental activity is “per se” passive activity — but the activity is nonetheless passive unless the taxpayer materially participates.

The Ninth Circuit cited the relevant statute, the regulations implementing that statute and a case decided by the U.S. Tax Court in support of its ruling. One regulation, for example, states that “a real estate professional’s rental real estate activity is a passive activity unless the professional materially participates in the activity.” According to the Tax Court, case law requires that a real estate professional claiming rental real estate loss deductions meet the “material participation” requirement.

Proceed with caution

If you’re planning to take advantage of the real estate professional exception, don’t assume that qualifying as such a professional alone satisfies your burden. You’ll need proper documentation of your material participation in the rental property for each tax year you claim a deduction.