Amanda is a full bank teller who owns an
apartment building, Lusignan Realty. During the year Amanda performed 680 hours
in real estate rental activity for Lusignan Realty. For the year her salary as
a bank teller was $55,000. Amanda generated a loss of $18,000 from the real
estate rental activity she performed for Lusignan Realty. Amanda came to me the
accountant and asked if she can deduct the $18,000 loss from the real estate
activity from her salary income of $55,000.

            In the case Gragg v. U.S., “the taxpayers’
underlying theory, that wife’s status as a real estate professional
automatically rendered subject rental losses non passive and
deductible under Code Sec. 469(c)(7) regardless
of material participation.”1
However, “The panel held that Internal
Revenue Code § 469 allows real estate professionals to deduct
rental losses from
their taxable income, but only if they materially participate in rental activities.”2 According
to IRC section 469(c)(7)(B)(ii), “taxpayer performs more than 750 hours of
services during the taxable year in real property trades or businesses in which
the taxpayer materially participates.”3
The circuit judge on the case, judge Christen stated that “I.R.C. § 469,
restricted taxpayers’ ability to reduce their taxable income using passive
rental losses—that is, losses from rental properties they own but in which they
do not materially participate.”4 On
the other hand, “Gragg wanted to deduct rental losses without showing material
participation in the rental property.”5 But
the judge ruled that “they still must show material participation in
rental activities before
deducting rental losses.”6

            Amanda cannot deduct the real estate
rental activity loss of $18,000 from her taxable income of $55,000. She only
performed 680 hours of real estate rental activity services for Lusignan Realty
during the year which means that she did not materially participate in the real
estate rental activity. In order for Amanda to deduct the real estate rental
activity loss from her taxable income and materially participated, she had to
perform more than 750 hours of real estate rental activity services. Only if
she had performed more than 750 hours of real estate rental activity services
then she could have deducted the $18,000 from her taxable income of $55,000.
Amanda needs to materially participate in order for the $18,000 loss to be
classified as active loss because taxable income or loss is classified as
active income or loss. According to IRC (e)(2)(B), “”net active income” means the taxable income of the taxpayer for the taxable year.”7According
to the case, Gragg v. U.S., Amanda must always record the number of hours she
performs in real estate rental activity because the burden of proof will always
be on her. So the $18,000 real estate rental activity loss could be classified
as passive activity loss. According to IRC (c)(1)(A) & (B), “the term
“passive activity” means any activity which involves the conduct of any trade
or business and in which the taxpayer does not materially participate…also
includes any rental activity except for IRC section 469(c)(7)”8 After
discussing these details to Amanda, she wanted to know what to do with the
$18,000 loss.

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            In the case St. Charles Investment
Co. v. Comm., ” In each of the years 1988, 1989, and 1990, St.
Charles’s passive activities generated total
deductions in excess of the total gross income from the activities…which are non-deductible pursuant
to section 469(a).”9 On the other hand, “IRC Section 469(b) provides that PALs can be suspended and
“carried forward” to the following year.”10
According to IRC (g)(1)(A), “any loss from such
activity for such taxable year… shall be treated as a loss which is not from a
passive activity.”11
However, ” the Commissioner urges that once the loss becomes non-passive, it
can only be an NOL which is not governed by section 469.”12
In conclusion, “St. Charles’s suspended PALs from the years 1988, 1989, and
1990 are carried over to 1991 pursuant to section 469(b) and section 469(f)(2)
and  those suspended PALs associated with the activities disposed of in
1991 are fully deductible pursuant to section 469(g)(1)(A)”13

            Amanda can
carry forward the $18,000 real estate rental activity loss to the next year. According
to IRC section 469 (b), “any loss or credit from an activity which is
disallowed under subsection (a) shall be treated as a deduction or credit
allocable to such activity in
the next taxable year.”14
She can deduct the $18,000 real estate rental activity loss from any real
estate rental activity income in the future. Next year if she materially
participated (perform more than 750 hours” in real estate rental activity, any
income or loss real estate rental activity would be classified as active income
or loss. However, she can still deduct the $18,000 loss from the next year’s
active income, because the active income and the passive activity loss are from
the same activity. As stated in IRC section 469 (f)(3), “The term “former passive activity” means any activity which,
with respect to the taxpayer is not a passive activity for
the taxable year, but was a passive activity for any prior taxable
year.”15
Even though, Amanda might perform more than 750 hours of real estate rental
activity next year she can still deduct the $18,000 loss because it’s the same
activity perform.

            Amanda cannot deduct the $18,000
real estate rental activity loss from this year taxable income of $55,000
because she did not materially participate (perform more than 750 hours of
services) in the real estate rental activity during the year. She can convert
her real estate rental activity from a passive activity to an active activity
by performing more than 750 hours of services next year. Amanda doesn’t have to
worry that she wouldn’t be able to deduct the $18,000 loss because she would
only have active income, because the active income and passive activity loss is
from the same activity. Even though Amanda can deduct the passive activity loss
of $18,000 from the active income from the real estate rental activity, she
cannot deduct it from the taxable income (active income). Amanda also has to
proof that she materially participated in any real estate rental activity.

1 GRAGG v. U.S., 118 AFTR 2d 2016-5364 (831
F.3d 1189), Code Sec(s) 469; 7422, (CA9), 08/04/2016

2
GRAGG v. U.S., 118 AFTR 2d 2016-5364 (831 F.3d 1189), Code Sec(s) 469;
7422, (CA9), 08/04/2016

3 §469 Passive activity losses and credits
limited.

4 GRAGG v. U.S., 118 AFTR 2d 2016-5364 (831
F.3d 1189), Code Sec(s) 469; 7422, (CA9), 08/04/2016

5
GRAGG v. U.S., 118 AFTR 2d 2016-5364 (831 F.3d 1189), Code Sec(s) 469;
7422, (CA9), 08/04/2016

6 GRAGG v. U.S., 118 AFTR 2d 2016-5364 (831
F.3d 1189), Code Sec(s) 469; 7422, (CA9), 08/04/2016

7 §469 Passive activity losses and credits
limited.

8 §469 Passive activity losses and credits
limited.

9 ST. CHARLES INVESTMENT CO. v. COMM., 86 AFTR
2d 2000-6882 (232 F.3d 773), Code Sec(s) 469; 1371, (CA10), 11/14/2000

10 ST. CHARLES INVESTMENT CO. v. COMM., 86 AFTR
2d 2000-6882 (232 F.3d 773), Code Sec(s) 469; 1371, (CA10), 11/14/2000

11 §469 Passive activity losses and credits
limited.

12
ST. CHARLES INVESTMENT CO. v. COMM., 86 AFTR 2d 2000-6882 (232 F.3d 773),
Code Sec(s) 469; 1371, (CA10), 11/14/2000

13 ST. CHARLES INVESTMENT CO. v. COMM., 86 AFTR
2d 2000-6882 (232 F.3d 773), Code Sec(s) 469; 1371, (CA10), 11/14/2000

14
§469 Passive activity losses and credits limited.

15 §469 Passive activity losses and credits
limited.

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