Thursday, May 19, 2011

Real Estate Agent entitled to deduct rental activity losses

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As many of you know, a Tax Court Summary Opinion is written by a Special Trial Judge appointed by the Chief Judge of the Tax Court. Typically, these Summary Opinions are small cases that deal with a taxpayer merely proving his/her entitlement to deductions, or contesting income assigned to him/her. And, these opinion have no precedential value. However, every once in a while, we get a Summary Opinion that seems to involve an important issue.

Agarwal v. Comr., T.C. Summ. Opin. 2009-29, seems to be a case of first impression. I won’t bore you with a complete recitation of the facts (the Portfolio goes into great detail), but the general issue in the case was whether a California licensed real estate agent is entitled to deduct losses on her personal rental properties despite the fact that she’s not a licensed broker.

Section 469(c)(7) defines the term “real property trade or business” as “any real property development, redevelop, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.” (emphasis added). According to the court, the IRS’s position was simple – since the taxpayer wasn’t a licensed real estate broker, she was not in the “real property trade or business.”

The court disagreed and allowed the taxpayer to write off the entire amount of losses on her rental property. The court looked to the common usage definition of the term “brokerage” and not the California law definition of the term.

It is interesting to note some of the facts of the case. During the first year at issue in the case, the taxpayer lost $172 in her business of being a real estate agent (grossing only $13,912). During the second year, the taxpayer made a whopping profit of $718 from her business as real estate agent (grossing $14,119). However, despite such meager income figures, the court bought the fact that the taxpayer spent 1,400 and 1,600 hours, respectively, managing her rental properties and selling real estate during the years at issue, respectively, with 170 hours being spent looking after her two rental properties.

Further, taxpayer was allowed to deduct losses of $40,104.78 and $19,656, respectively, from her two rentals.

Obviously, this is a great case for real estate agents who own rental properties. First, according to this case, you need only be a real estate agent to be entitled to deduct rental losses. Further, you don’t have to show any substantial income or profits in your business as a real estate agent in order to be entitled to such deductions. This also seems to present a planning opportunity for those who own rental properties, i.e., go get your real estate license, sell a couple of properties to your friends, and you can seemingly write off your rental property losses.

For me, this case begs a couple of questions.

First, why was this opinion issued as a Summary Opinion? As a case of first impression, it seems that it would merit at least T.C. Memorandum distinction, if not a full Tax Court opinion status.

Second, given the lack of income (and gross receipts), why did the Tax Court buy the taxpayer’s assertion on the amount of hours she spent selling real estate?

Third, why did the court seemingly just dismiss the notion that one must actually be a “broker” to be considered engaged in “brokerage”. I believe all states make a distinction between real estate agent and real estate broker. In many states, there is a certain amount of time a real estate agent needs to be in business before he/she can apply to be a broker.

Fourth, would the IRS have argued differently if it knew that the court would allow any real estate agent who could claim to work 1,400-1,600 hours (despite very little income) to deduct pretty substantial (in comparison) rental losses? According to the court, the IRS merely argued that since the taxpayer wasn’t a real estate broker under California law, she didn’t qualify under the Code. Well, what if she was broker (she later became one), and still did very little business selling real estate. Is the IRS conceding that those individuals would be entitled to the loss deductions.

In any event, this was a very interesting case and we believe it merited a full discussion in Port. 549.

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