Updated December 8, 2020
In past newsletters or articles, I have discussed what is required of a real estate investor who seeks to qualify under Code Sec. 469 as materially participating in real estate. A recent Tax Court decision addressed this very same issue and held that a licensed real estate agent’s activities counted for purposes of the Code Sec. 469 passive loss exception for qualifying real estate professionals. She didn’t have to be licensed as a real estate agent to be treated as engaged in the real estate brokerage trade or business. Because she met the material participation standard for qualifying real estate professionals, the agent, and her husband could claim losses they incurred on two rental properties they owned.
During 2001 and 2002, Mr. and Mrs. Agarwal owned two rental properties. Mr. Agarwal worked full-time as an engineer and his wife worked full-time as a real estate agent for a brokerage firm under an independent contractor arrangement. For those years, Mrs. Agarwal was licensed as a real estate agent only under state law (California), not as a broker. Together the spouses spent approximately 170 hours managing one of their rental properties and approximately 170 hours managing the other rental property. They were the only persons who managed their rental properties. Mrs. Agarwal spent a total of 1,400 and 1,600 hours managing the couple’s rental properties and selling real estate in 2001 and 2002, respectively. On their Schedule E for 2001, they claimed a $40,000 loss from their rental properties; for 2002, they claimed a $19,600 loss.
The IRS disallowed the losses on the ground that Mrs. Agarwal was a licensed real estate agent, not a licensed real estate broker. It argued that under California law, she couldn’t be engaged in a brokerage trade or business, and therefore, was not engaged in a real property trade or business as defined by Code Sec. 469(c)(7). Since her activities didn’t count as a real property trade or business, the Agarwals didn’t meet the Passive Activity Loss “PAL” exception for qualifying real estate professionals who meet the material participation standard in Code Sec. 469(c)(7)(B). The Agarwals, on the other hand, maintained that Mrs. Agarwal was in the real property trade or business because as an agent she brought together buyers and sellers.
Real estate agent’s activities count for PAL real estate exception.The Tax Court found that Congress is presumed to have defined the term “brokerage” in its common or ordinary meaning, and that for PAL purposes, the “business” of a real estate broker includes, but is not limited to:
- selling, exchanging, purchasing, renting, or leasing real property;
- offering to do the activities in (1), above;
- negotiating the terms of a real estate contract;
- listing of real property for sale, lease, or exchange; or
- procuring prospective sellers, purchasers, lessors, or lessees.
Whether Mrs. Agarwal is characterized as a broker or a salesperson for State purposes was irrelevant for federal income tax purposes, the Tax Court said. Rather, the test is whether she was engaged in “brokerage” within the meaning of Code Sec. 469. Consistent with her real estate salesman’s license and pursuant to her contract with the brokerage firm, Mrs. Agarwal was engaged in “brokerage”; i.e., she sold, exchanged, leased, or rented real property and solicited listings. Therefore, she was engaged in a “brokerage” trade or business within the meaning of Code Sec. 469(c)(7).
The Tax Court concluded that because Mrs. Agarwal owned an interest in rental property, performed more than one-half of her personal services in real property trades or businesses in which she materially participated, and performed more than 750 hours of services in real property trades or businesses in which she materially participated, she was a qualifying real estate professional for PAL purposes. Because she materially participated with respect to each rental property owned by the Agarwals, they were entitled to deduct their 2001 and 2002 Schedule E losses.
Remember, if one spouse devotes 750 hours a year (be sure to track your hours) and 50% of their time to real estate activities, the PAL exception applies and real estate losses may be deducted on your 1040 Schedule E.