Agarwal v. Comm’r: Salespeople Can Claim Deduction

The Tax Court has considered whether an exception to the passive activity loss rules only cover licensed real estate brokers or applies to all real estate professionals.

Shri and Sudha Agarwal (“Taxpayers”) were a married couple who owned two rental properties in 2001-02. During that period, Sudha worked as a full-time real estate salesperson, reporting her commissions on the couple’s tax returns. She did not have a broker’s license, and worked as an independent contractor with a brokerage firm. Shri worked full-time as an engineer during this period.

On their tax returns, the Taxpayers reported rents of approximately $36,000 for 2001 and expenses of $75,000, for a loss $40,000; in 2002, they reported rents of $45,000 and expenses of $65,000, for $20,000 loss. The Internal Revenue Service (“IRS”) disallowed these loss deductions because it found that the Taxpayers didn’t qualify as a real estate professional. The IRS determined that the Internal Revenue Code (“Code”) limited these deductions to licensed real estate brokers, not all licensees. The Taxpayers appealed the IRS’s determination.

The United States Tax Court ruled in favor of the Taxpayers and allowed them to deduct their losses. The Code generally disallows the deduction of passive activity losses. A “passive activity loss” is a loss deduction from any trade or business in which the taxpayer does not materially participate. Property rental activity is treated as a “per se” passive activity under the Code. If the taxpayer qualifies as “real estate professional” under the Code, then the rental activity is considered part of the taxpayer’s trade or business and the taxpayer can claim an unlimited deduction for rental activity losses. When filing a joint return, if either spouse qualified as a real estate professional, then the exception will apply for the entire return.

A taxpayer qualifies as a “real estate professional” when: first, more than half the personal services performed during the tax year are in the real property trade or business and the taxpayer “materially” participates in these activities; and second, the taxpayer performs more than 750 hours in the real estate profession during the tax year. The definition for “real property trade or business” lists a variety of activities including property development, construction, rental, management, or “brokerage trade or business”. Because Sudha was not a broker, the IRS stated that she did not qualify for the deduction.

The court disagreed with the IRS’s narrow construction “brokerage trade or business”. Instead of limiting the definition of brokerage to that found in state license laws, the court stated that “brokerage trade or business” 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 property for sale, lease, or exchange; or (5) procuring prospective sellers, purchasers, lessors, or lessees.

Since Sudha engaged in the above “brokerage trade or business activities” in her duties as a salesperson and this was her primary business activity, she qualified as a “real estate professional”. Therefore, the court overruled the IRS’s determination and allowed the Taxpayers to claim the passive activity loss deduction.

Agarwal v. Comm’r, No. 12670-07S (T.C. Mar. 2, 2009), 2009 WL 513391 (U.S.Tax Ct.,2009)

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