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Gragg v. United States: IRS Tax Deductions Clarified

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Many real estate professionals use their knowledge and expertise to invest in real estate. They know a good deal when they see it, know the laws they need to navigate, and likely have contacts in property management or are confident in their ability to manage a rental property. Rental losses are also potentially deductible, insulating investors from some risk. But how does this deduction work? In Gragg v. United States of America; Internal Revenue Service a real estate professional was found to not be eligible for a tax deduction that they felt they were entitled to, shedding light on the details of the law—real estate agents who invest in rental properties should not necessarily expect these tax deductions unless they can prove that their investment involves material participation.

Gragg v. United States has provided us with a clarification on the Internal Revenue Code’s definition of material participation in rental activities. If a real estate professional materially participates in their rental activities, losses may be deducted. Passive activity in a rental investment, on the other hand, is not grounds for a tax deduction. The court case cites Section 469 of the Internal Revenue Code (I.R.C.), which defines material participation as activity in which the “taxpayer is involved in the operations of the activity on a basis which is—(a) regular, (b) continuous, and (c) substantial.” Rental activity is typically classified as “per se passive” and not eligible for any deductions under the material participation rule. Yet Section 469 (c)(7) of the I.R.C. has established that for “taxpayers who qualify as real estate professionals, the per se rental bar” does not apply, meaning real estate professionals have a greater ability to deduct losses on rental investments because real estate is their profession.

So how do these two sections of code work together? Since Gragg is a real estate professional, she should have been able to claim a deduction, right? Yet the court sided with the IRS and found Gragg ineligible for the deduction. How does this work?

The explanation lies in the interaction of the two sections of code. The court states that the effect of the real estate professional exception to the law is to remove the automatic classification of rental activity as passive—it does nothing to the general rule that material participation is necessary for exemption. Thus without proof of material participation, a real estate professional invested in a rental property cannot deduct losses.

Essentially there is a two step process to earn a tax deduction. First, one must be a real estate professional. Step two is to demonstrate material participation, something Gragg was incapable of proving. Two pages of undated notes were offered, but as those notes had not been present for previous court proceedings the court in this case declined to address them as a new argument.

The lesson for the real estate professional with rental investment properties—document your material participation. Prove activity in property management. Without this proof your deductions will be rejected by the IRS and you will find yourself paying more in taxes than you would have needed to if you had documented your material participation properly.

After a break in my posts I am back with this piece. Let me know what you think! Does this affect you or anyone you know or work with? Does this ruling affect your market? If so, how?


Posted by

Cody Carmen

Dick Greenberg
New Paradigm Partners LLC - Fort Collins, CO
Northern Colorado Residential Real Estate

Hi Cody - Excellent post and an important consideration for agents who also invest. We faced that issue way back when we first began doing our own investing, and fortunately had an accountant who kept us on the right track.

Dec 29, 2016 12:04 PM
Kartik Subramaniam

Dick Greenberg thank you! This is definitely an issue area where an accountant could be incredibly helpful. I'm sure most good real estate pros could handle these hurdles on their own with the research and time invested (after all, real estate pros end up learning quite a bit about the law, accounting, and finance), but sometimes it isn't worth the time. Busy real estate pros hire accontants for the same reason busy people hire real estate pros: an efficient professional can really be worth the cost, especially when the alternative is a lot of hours of personal time invested. 

Dec 29, 2016 12:08 PM
Roy Kelley
Retired - Gaithersburg, MD

This is great information to share with real estate investors.

Have a most productive new year!

Jan 09, 2017 06:11 PM
Georgie Hunter R(S) 58089
Hawai'i Life Real Estate Brokers - Haiku, HI
Maui Real Estate sales and lifestyle info

Hmmm, that was interesting.  I suppose it makes sense to be more involved with the property management and take an active role, and therefore be able to deduct any losses.

Jan 24, 2017 11:25 PM
Beth Bromund
Coldwell Banker Weir Manuel - Rochester, MI
REALTOR (248) 651-3500

Interesting and important post for people who would like to take those deductions.

Feb 13, 2017 09:58 AM