Generally, if a taxpayer’s activity is subject to the passive activity loss rules, they will not be permitted to deduct any loss from that activity on their tax return. Instead, that loss is considered a passive activity loss that is disallowed in the current year and is carried forward to future tax years.
How Material Participation Tests Work for Trade or Business Activities
In general, a taxpayer’s trade or business activity is passive and their losses in that trade or business are limited by the passive activity rules, unless the taxpayer materially participates in that activity by satisfying any one of the seven material participation tests, which we’ll review in more detail below.
How Material Participation Tests Work for a Real Estate Activity
The passive activity rules work a bit differently for real estate activities. To bypass the passive activity rules for a rental activity, a taxpayer must materially participate in the activity. They must also qualify as a real estate professional for the year. However, even if a rental activity is a passive activity, a taxpayer may still deduct up to $25,000 in losses in rental activities that they actively–not necessarily materially–participated in during the year as a special allowance. Active participation has a lighter standard than material participation. In general, a taxpayer is considered to have actively participated in an activity if they own at least 10% of the activity and make management decisions for the activity. The amount of the $25,000 special allowance is reduced by 50% of the modified adjusted gross income that exceeds $100,000. So once a taxpayer’s modified adjusted gross income reaches $150,000, they can’t utilize this special allowance at all.
Example of a Material Participation Test
One of the seven material participation tests is whether a taxpayer has participated in an activity for more than 500 hours during the year. So if a taxpayer participates in an activity for 600 hours during the year, they are considered to have materially participated in the activity for the year.
Types of Material Participation Tests
There are seven material participation tests. If a taxpayer satisfies any one of these tests for a trade or business activity, they are not subject to the passive activity rules for the year. If a taxpayer satisfies any one of these tests for a rental real estate activity and the taxpayer also qualifies as a real estate professional for the year, the activity is not subject to the passive activity rules for the year. The seven IRS material participation tests are listed below. Note that as long as a taxpayer meets one of these tests for a given activity, they are considered to have materially participated in that activity for the year. The IRS has some guidelines in place to avoid abuse. For example, to meet test number 7, the taxpayer must have participated in the activity for more than 100 hours during the year. Also, if the taxpayer manages others in the activity, the taxpayer’s time spent managing the activity doesn’t count toward this 100-hour test if there was another compensated manager for the activity during the year, or if someone else spent more time managing the activity than the taxpayer did, regardless of the manager’s compensation. The record-keeping standards for purposes of verifying one’s material participation in an activity are not as stringent as those for, say, a mileage log. However, taxpayers should be able to produce some written evidence that would satisfy a reasonable third party that they participated in the activity to the extent they claimed they did. Note that when determining whether a taxpayer materially participates in an activity, they may include their spouse’s participation in the activity, even if they don’t file jointly. Finally, unless a taxpayer is involved in the day-to-day management or operations of an activity, they may not count the time spent performing tasks that an investor would typically perform, such as reviewing financial statements.
