Generally speaking, real estate rental activity is automatically treated as a "passive activity" and, subject to certain exceptions, losses from passive activities can only be deducted against income from other passive activities. Consequently, losses from rental property generally cannot be deducted to reduce taxable income from wages or investments (e.g., interest and dividends).
However, there is an exception to the automatic treatment of rental activity as passive that is commonly referred to as the "real estate professional exception." Under this exception, if you qualify as a real estate professional and you materially participate with respect to the rental property, the losses from that rental property are deductible against non-passive income. A person qualifies as a real estate professional if they meet the following two requirements:
1. More than one-half of all personal services performed by the individual are performed in real property businesses in which the individual materially participates, and
2. The individual performs more than 750 hours of services during the year in real property businesses in which the individual materially participates.
On March 2, 2009, the United States Tax Court held that a full-time real estate agent qualified as a "real estate professional" and was not subject to the deduction limitation on losses from two rental properties. Agarwal v. Commissioner , TC Summary Opinion 2009-20. During 2001 and 2002, Mrs. Agarwal was licensed and worked full time as a real estate agent in California. She worked for a real estate brokerage firm pursuant to an "Independent Contractor Agreement (between Broker and Associate Licensee)." The contract provided that she was an independent contractor and, consistent with that status, she was not paid a salary and was issued a Form 1099 for commissions she received. The contract required Mrs. Agarwal to sell, exchange, lease, or rent properties and solicit additional listings, clients, and customers.
Mrs. Agarwal and her husband owned two rental properties. They spent approximately 170 hours each year managing each property and they were the only ones engaged in managing the properties. In 2001 and 2002, Mrs. Agarwal spent 1,400 and 1,600 hours, respectively, selling real estate and managing their rental properties. The Agarwal's deducted losses from their rental properties of approximately $40,000 in 2001 and approximately $19,000 in 2002. There was no question as to whether Mrs. Agarwal rendered more than one half of her services during the year working as a real estate agent and she clearly met the 750 hour requirement. However, the IRS argued that working as a real estate agent is not participating in a "real property trade or business." For purposes of the real estate professional exception, a "real property trade or business" includes, among other activities, a "brokerage trade or business." The IRS argued that under California law, a licensed real estate agent is not a licensed real estate broker and, therefore, Mrs. Agarwal did not materially participate in a "brokerage trade or business." The Tax Court determined that the term "brokerage" should be read in the common and ordinary sense and, as such, the "business of a real estate broker" includes listing real property for sale, lease, or exchange and procuring prospective sellers, purchasers, lessors or lessees. The Tax Court stated that whether a person is a broker or sales person for state law purposes is irrelevant for federal income tax purposes. Accordingly, the Court ruled that since Mrs. Agarwal sold, exchanged, leased, and rented real property and solicited listings, she was engaged in a "brokerage" trade or business. Since she performed more than one-half of her personal services in a real property trade or business (i.e., as a real estate agent) and she performed more than 750 hours of services in such real property trade or business, she met the real estate professional exception.
While the Court did not specifically articulate the basis for concluding that she "materially participated" with respect to the rental properties themselves, the facts indicate that these properties were exclusively managed by she and her husband. One of the tests for material participation is whether a person's participation (including that of his or her spouse) constitutes substantially all of the participation in the activity of all individuals for the year. Based on the facts, the taxpayers would have met this test.
The Court’s decision confirms what many tax practitioners have probably already concluded. While the decision is a summary opinion and cannot be relied upon as binding authority, it is nevertheless clear support for treating a real estate agent as a real estate professional.