Charles Gragg v. United States

Citations: 831 F.3d 1189; 118 A.F.T.R.2d (RIA) 5364; 2016 U.S. App. LEXIS 14270; 2016 WL 4136982Docket: 14-16053

Court: Court of Appeals for the Ninth Circuit; August 4, 2016; Federal Appellate Court

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Internal Revenue Code § 469 permits real estate professionals to deduct rental losses from taxable income only if they materially participate in rental activities. The statute establishes that generally, activities in which a taxpayer does not materially participate are considered passive, making related losses non-deductible. Although rental activities are typically classified as per se passive under § 469(c)(2), real estate professionals can bypass this classification. However, they must still demonstrate material participation as defined by the general rule in § 469(c)(1) to qualify for loss deductions. The case involves the Graggs seeking to deduct rental losses based on Delores Gragg's real estate professional status, but the court concludes that material participation is still a requirement for these deductions, in alignment with the statutory text, regulations, and case law.

In 1993, Congress recognized that the Tax Reform Act of 1986 had excessively restricted the ability of individuals engaged in real estate to offset losses from rental activities against other income. Consequently, Congress enacted § 469(c)(7), which creates an exception to the general rule that rental losses are passive and not deductible. This case concerns the interpretation of that exception. 

Delores and Charles Gragg, who incurred rental losses in 2006 and 2007, sought to deduct these losses on their joint tax returns. Delores, a licensed real estate agent, claimed her professional status allowed them to treat these losses as nonpassive. The IRS audited their returns, requested documentation on their rental activities, and subsequently disallowed the deductions, asserting the Graggs failed to demonstrate material participation in their rental properties. 

After paying the assessed deficiencies, the Graggs filed refund claims with the IRS, arguing that Delores's status as a real estate professional should automatically categorize their rental losses as nonpassive, thereby exempting them from proving material participation. The IRS denied these claims, leading the Graggs to file a lawsuit in district court for a refund. Both parties filed cross motions for summary judgment, with the court ruling in favor of the government. 

The appeal revolves around whether § 469(c)(7) automatically classifies a real estate professional's rental losses as nonpassive or simply removes the passive classification imposed by § 469(c)(2). The court's analysis indicates that the statute's language supports the government's interpretation, which maintains that rental activity remains passive unless the taxpayer can prove material participation as outlined in § 469(c)(1) and (2).

The Graggs argue that once a taxpayer qualifies as a real estate professional under § 469(c)(7), all rental losses become nonpassive and deductible without regard to material participation. However, this interpretation is not supported by the statute. The § 469(c)(7) exception allows for the per se rental bar to be disregarded, but the general rule under § 469(c)(1) remains applicable, classifying the activity as passive unless the taxpayer materially participates. Treasury Regulation § 1.469-9(e)(1) specifies that a real estate professional can only treat rental losses as nonpassive if they materially participate in those rental activities. Moreover, even real estate professionals must demonstrate material participation in rental activities distinctly from other real estate activities to claim rental losses as nonpassive, as outlined in § 1.469-9(e)(3)(i). The Tax Court has rejected the Graggs’ interpretation, affirming that material participation is necessary for claiming such deductions. This position aligns with prior cases, including Perez v. C.I.R., where the Tax Court ruled against similar arguments and emphasized the importance of meeting the material participation requirement. The Graggs' reliance on Agarwal v. C.I.R. does not support their stance, as that case addressed a different issue related to the definition of a real estate professional.

The Graggs argue that Agarwal allows for the calculation of material participation based on a taxpayer’s overall real estate activities, which they believe negates the need to demonstrate material participation for each rental activity. However, the court in Agarwal indicated that material participation must be assessed individually for each rental activity, thus not permitting the aggregation of rental and nonrental activities. The court found no compelling reason to deviate from the Tax Court's ruling in Perez. Although the Graggs claimed on appeal that they could meet the material participation requirement through safe harbor provisions in the Treasury Regulations, they did not present this argument in the district court. In that court, they conceded that Delores Gragg did not meet the material participation requirements for each rental activity and argued instead that these requirements were irrelevant due to her status as a real estate professional. The appellate court declined to consider their new argument based on minimal evidence from 2007, as the Graggs did not demonstrate material participation for the years 2006 and 2007 in the district court, rendering the rental losses non-deductible. The court affirmed that even real estate professionals must show material participation in rental activities to deduct losses, consistent with the intent of Congress to limit deductions for passive losses in real estate investments.