The recent Tax Court decision in Charles Gragg and Delores Gragg v. Commissioner of Internal Revenue, stressed the importance of taxpayers correct determination of material participation in rental real estate activity to avoid passive loss treatment. Only participation on the rental real estate activities may be considered when determining if the taxpayer materially participates.
Generally, losses from rental real estate activities are considered passive. The term passive activity includes any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. Passive losses may not be used to offset most taxable types of income. However, taxpayers who materially participate in their rental real estate activities are not subject to this passive-loss limitation.
There are two qualifications that taxpayers must meet in order to be deemed to materially participate:
1. More than one half of the personal services performed in trades or businesses are performed in real property trades or businesses in which the taxpayer materially participates, and
2. The taxpayer must perform more than 750 hours of service.
The facts in the Gragg case are as follows:
In 2006 and 2007, taxpayers Charles and Delores Gragg reported rental real estate losses in excess of their rental real estate income. Charles and Delores argued that because Delores is a qualified real estate agent, her full-time occupation relieves the couple from having to demonstrate material participation.
Delores provided the court with estimates of the amount of time spent rather than actual rental records. In 2006, Delores had estimated that she spent 40 hours over a two month period and an additional 100 hours after the tenants had moved out. She also claimed to have spent approximately 200 hours at another property dealing with tenant problems, and approximately 300 hours restoring property.
The records did not reflect a means of how the hours were calculated. Even if the amount of hours were above 750, Delores would have been required to make an election in order to treat all real estate properties as one activity, which was not done. Since there was no election, the taxpayers were required to separately establish their material participation for each of their rental properties.
The records do not show any estimates for 2007. Because of this, the court concluded that the estimates provided by Delores were not a “reasonable means” of documenting her material participation. The documents provided were deemed unreliable and not deemed a reasonable means to show participation.
Delores Gragg’s real estate activities are treated separately from her rental activities. Her status as a full-time real estate agent did not establish her material participation in each of her separate rental real estate activities. Further, she failed to demonstrate her material participation in the two rental properties which were deemed distinct from her real estate agent job. Therefore, the court decided that the taxpayers did not materially participate in their rentals even though Delores Gragg worked as a full-time real estate agent.