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Material participation refers to a classification the IRS uses that focuses on the taxpayer's level of participation in their business, rental, or income-producing activity. An activity is a single economic unit used to measure gains or losses. If your income-producing activity rises to the level of material participation, then the income you generate will be characterized as active income (i.e., non-passive income) and you can use any losses incurred to offset other categories of income (i.e. W-2 wages). Additionally, as a taxpayer, you will not be subject to the Net Investment Tax, a surtax that applies to investors over a certain income threshold.
The IRS has set out seven tests to meet the material participation standard. We will review those tests below.
If you meet one of the seven tests for material participation, as a taxpayer you're in luck this tax season! The income generated will be characterized as active, and you will not be subject to the passive activity loss rules. While this is great news, you should note that you will have to meet the material participation test annually. For future years, you will have to meet one of the seven tests if you want to claim material participation for the tax year.
You should also note that some business activities do not qualify for the material participation test. These activities are:
For this article, we will focus on rental activity.
In general, real estate activities are automatically treated as passive. This means that you will be unable to deduct your real estate losses against your wages, salaries, interest, or dividends. This is the general rule, unless you meet one of the applicable exceptions: (1) you are a real estate professional who is a material participant or (2) you actively participate in rental activities.
If you do not qualify as a real estate professional, your real estate activity may meet the standard for active participation. If you actively participate in real estate activities (i.e., you make management decisions) and you own more than 10% interest in the real estate trade or business, then your income will not be considered passive. As an active participant, if you meet certain criteria, you may be able to claim the $25,000 special loss allowance.
With either exception, you can elect to group all your real estate activities into a single activity. This election is irrevocable, and cannot be changed later. This process can get complicated, so consult your tax advisor before electing irrevocable grouping.
Being declared a material participant in your trade, business, or income-producing activity has many tax advantages. This is especially true if you engage in real estate activities. One of the many advantages is that you can use any losses incurred to offset your income from other sources. To put yourself in this advantageous situation, careful tax planning is a must! Consult a tax advisor if you have any questions about the strategies outlined above.
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