The Tax Court held that a woman’s work as an independent contractor for a real estate agency enabled her and her husband to deduct losses because they were incurred from a real property trade or business rather than a passive activity. According to the court, the taxpayers’ real estate activities met the requirements of a real property brokerage trade or business under IRC § 469(c)(7)(C). The fact that the wife was not a licensed broker under California state law was irrelevant in determining whether she operated a real property brokerage trade or business for federal income tax purposes.
Taxpayers’ losses from passive activities generally are deductible only to the extent of their passive income. A passive activity is one where a taxpayer does not materially participate—that is, is not involved in the activity’s operations on a regular, continuous and substantial basis. Generally, real estate rental activity is passive; however, it can qualify as a real property trade or business if the taxpayer satisfies a twofold test: The amount of personal services performed in real property trades or businesses by taxpayers in which they materially participate must exceed 750 hours and 50% of personal services performed in all trades or businesses during the taxable year (section 469(c)(7)(B)). For a married couple filing jointly, the test can be satisfied by either spouse, but only if that person meets both tests. Section 469(c)(7)(C) lists various activities that can be a real property trade or business, including a real property brokerage.
In 2001 and 2002, Shri Agarwal was employed as an engineer while his wife, Sudha, was a full-time real estate agent at a Century 21 agency in California. She was an independent contractor with the company, and her duties included selling, exchanging, leasing and renting properties. In addition, she was required to attract new listings and clients. During each of the years 2001 and 2002, the couple also spent 170 hours managing two rental properties they owned. In 2001 and 2002, Sudha spent 1,400 hours and 1,600 hours, respectively, performing her Century 21 activities and managing the two rental properties. The couple’s rental properties generated losses of $40,105 in 2001 and $19,656 in 2002, which they deducted on their federal income tax returns for those years. The IRS disallowed the deductions, prompting the taxpayers to petition the Tax Court for relief.
The IRS claimed that Sudha did not satisfy the section 469(c)(7)(C) definition of a real property trade or business because she was not in a brokerage trade or business. Since she was not a licensed real estate broker in California, the IRS argued, she could not be in the brokerage trade or business, and thus the activity was passive.
The Tax Court rejected this argument, stating neither section 469 nor its legislative history defines “brokerage,” and thus the common meaning of the term should be used. The court concluded that the business of a real estate broker includes “(1) selling, exchanging, purchasing, renting, or leasing real property; (2) offering to do those activities; (3) negotiating the terms of a real estate contract; (4) listing of real property for sale, lease, or exchange; or (5) procuring prospective sellers, purchasers, lessors, or lessees.” Since her duties at Century 21 included selling, exchanging, leasing and renting real property and finding new listings, the court concluded she was engaged in a brokerage trade or business at Century 21 within the meaning of section 469(c)(7)(C). Thus, Sudha spent sufficient time in real property trades or businesses in 2001 and 2002 to be able to deduct the losses.
Shri G. and Sudha Agarwal v. Commissioner , TC Summary Opinion 2009-29
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin –Superior.