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. Additionally, as a taxpayer, you will not be subject to the Net Investment Tax.
The IRS has set out seven tests to meet the material participation standard. We will review those tests below.
Material participation test
- You participated in the activity more than 500 hours during the tax year (most utilized test). Note that if you are married and file a joint return, the hours your spouse spends participating in the business activity count toward the 500-hour requirement for material participation. This is great news for taxpayers who have a spouse who is also engaged in the same income-producing activity.
- Your participation in the activity constitutes substantially all the participation in the business, trade, or income-producing activity (i.e., you performed most of the work).
- Your participation in the activities during the tax year exceeds 100 hours and you did not perform fewer hours than any other individual who participates in the activity (this rule does not apply to rental activities).
- Your participation in the activity is significant, and the total value of all the significant activities that you participated in exceeds 500 hours. This is known as a significant participation activity.
- You materially participated in the activity during any five of the 10 tax years before the current tax year.
- If your income-producing activity is a personal-service activity, you materially participated if that activity occurred during the three years before the current tax year. (These years do not need to be consecutive.)
- If you participated in the activity for more than 100 hours during the tax year and you can demonstrate based on the facts and circumstances that your activity was regular, continuous, and substantial during the tax year, then the IRS will construe you as a material participant.
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.
Considerations for the material participation test
You should also note that some business activities do not qualify for the material participation test. These activities are:
- Time spent as an investor (unless the taxpayer can show the time was spent on management activities).
- The activities of a limited partner in a limited partnership (unless certain criteria are met).
- Rental activity (unless one of the two exceptions applies).
For this article, we will focus on rental activity.
Rental activities and material participation
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 the applicable expectations: (1) you are a real estate professional who is a material participant or (2) you actively participate in rental activities.
What is a real estate professional?
For tax purposes, to be considered a real estate professional you must meet certain criteria. These criteria must be met even if you have a state license to practice as a real estate professional:
- More than 50% of the personal services you perform in all trade, business, or income-producing activities involve your real property trade or business in which you materially participate.
- You perform more than 750 hours of these personal services in real property trades or businesses in which you're the material participant. To meet the 750-hour requirement, none of the time can be spent as an investor and none of the hours can be performed by a spouse. That means to meet this element, the hours spent depend upon one individual’s participation.
Also, note that any personal-service activity you perform as an employee is not treated as engaging in a real property trade or business unless that employee is at least a 5% owner of the business. If you are deemed a real estate professional for tax purposes, you are not subject to the passive loss rules and may deduct losses from your real estate rental income against ordinary income.
What is an active participant?
If you do not qualify as a real estate professional, your real estate activity may meet the prongs 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 be considered nonpassive. As an active participant, if you meet certain criteria, you may be able to claim the $25,000 special loss allowance.
What is irrevocable grouping?
With either exception, you can elect to group all your real estate activities into a single activity. Once you make this election, the choice is irrevocable. If this step is a bit confusing, always remember that there's support to help you make decisions, so consulting a tax advisor may be in your best interest.
Millionacres bottom line
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 category, careful tax planning is a must! If you're unable to plan on your own, always consult a tax advisor so that you don't have to go at it alone.