True or false? If a person meets the IRS test for being a qualified real estate professional, then that person is automatically entitled to deduct losses from his or her rental property against ordinary income. [note: "qualified real estate professional" is not a term used in the tax code, but it's easier to use than continually referring to IRC § 469(c)(7)(B)]

If you answered "true" you have plenty of company within the real estate community. Being in a position to deduct rental property losses against ordinary income is often touted as a benefit -- one of the perks -- of being a (pretty much) full-time real estate professional. The problem is, there may be a bit more to it than is often implied. The IRS would say the statement above is false. It's a bit more complicated.

Interested parties would do well to acquaint themselves with the case of Gragg v. United States of America (United States District Court, Northern District of California, Oakland Division, Case No. CV 12-3813-YGR). Here's what happened.

In 2009, the IRS conducted an audit of the taxpayers' returns for 2006 and 2007. In both years, losses from rental properties were deducted against ordinary income. In both years Mrs. Gragg's occupation was listed as "real estate sales."

The deductions were disallowed. There was an additional assessment of $14,874 for 2006, and an assessment of $43,499 for 2007. Both assessments, plus penalties and interest, were paid in full. Then, in 2011, the taxpayers filed Claims for Refund for both years. The basis for the refund was "Taxpayer is a real estate professional and as such is not subject to the passive loss limitations which the IRS disallowed."

The claims were denied and the taxpayers filed a lawsuit. In October of 2013, the government (IRS) filed a motion for summary judgment -- essentially a motion to dismiss. The motion specifically says "The United States does not dispute that Plaintiff Delores Gragg is a real estate professional under 26 U.S.C. § 469(c)(7) for both the 2006 and 2007 tax years." Subsequently, the taxpayers filed a motion of opposition, and the government then filed a reply to the opposition. We pick it up from there.

The taxpayer's case rests on a reading of the Internal Revenue Code such that "26 U.S.C. § 469(c)(7)(A)(i) expressly states that the rental real estate activity of any taxpayer who qualifies for the real estate professional exception will not be considered passive activity." [my emphasis] If rental activity is not passive activity, then rental losses can be used to offset other income. In short, the taxpayers' position was that the answer to the question at the beginning of this column is "True".

But the IRS, referring to other parts of the tax code, said that determining a real estate licensee's professional status was just one step in the process. "However, the inquiry does not end there. Instead, the rental real estate activities of qualifying taxpayers will continue to be treated as passive activities unless the taxpayer materially participates in each of those rental real estate activities….Material participation for this purpose has the same definition as under section 469(h)(1), meaning that the taxpayer must be involved in the operations of the activity on a basis that is regular, continuous and substantial." [my emphasis]

Another section of the code (26 C.F.R. §1.469-5T) provides a 7 factor test (e.g. did the individual participate in the activity for more than 500 hours during the year?) such that at least one of them must be met in order to demonstrate that the taxpayer, albeit a qualified real estate professional, has materially participated in the rental activity.

The Court agreed with the IRS and the motion for summary judgment was granted March 31, 2014. We shall wait to see if there is an appeal. Meanwhile, be careful about deducting those rental losses.

(By the way: I fully expect that there will be someone out there who will let me know that they successfully deducted losses on rentals where they had practically no involvement with the rental activity. My only question would be: were you audited? Every deduction "works", as long as you haven't been audited...)

Bob Hunt is a director of the California Association of Realtors®. He is the author of Real Estate the Ethical Way.