Gragg v. United States

Facts: An income property owner acts as a real estate agent as their primary occupation. The owner reports their rental income losses as an adjustment to their adjusted gross income (AGI) on their income tax return, which offsets other income from taxation. The owner provides evidence to the Internal Revenue Service (IRS) they are a real estate professional, but does not document any material participation in the operation of the property.

Claim: The IRS claims the owner is restricted from using passive income losses to offset their AGI since the owner did not show they spent the minimum required time in rental activity to qualify them as a material participant, thus barring their rental losses from being classified as part of their real estate business.

Counterclaim: The owner claims they are entitled to take the deduction against their AGI since their rental loss­es are automatically non-passive by virtue of their status as a real estate agent, and they therefore do not need to prove material participation.

Holding: A California appeal’s court holds the property owner may not deduct the passive losses in their real estate investment from their AGI without materially participating in the operations of the property since their status as a real estate agent does not exempt them from the material participation requirement. [Gragg v. United States (August 4th, 2016) __CA4th__]

Editor’s note — For a thorough discussion of the proper use of rental operating losses to offset business income, investment income and profits, see Tax Benefits of Ownership Chapter 10: Commingling rental losses with other income.

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