IRS Can Use Material Participation Tests Against You As Well

By Jason Watson, CPA
Posted Sunday, May 25, 2025

At the risk of repeating ourselves from a previous section, there are times when you want your participation to be passive- usually when you have passive income that is being taxed, and you want to use it to offset passive losses. Huh? You are a successful business owner, and you are sunsetting a bit, and therefore you would like to consider your participation passive since you have managers and other smart people running things.

This would allow you to take your taxable business profits and offset them with rental property losses without having to worry about using real estate professional status or short-term rental loophole as your escape hatches. Recall the passive, active and material participation levels we discussed in our material participation rules section on page 129 where passive losses can only offer passive income. Therefore, calling business income passive income might be a good thing, right?

In response, and as they see you coming a mile away, the IRS might use “5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years” above to consider your business income (profits) not passive. Therefore, your business income is a different color of money and cannot be offset by rental property losses.

See our your small business as a passive income activity section and passive income generators (PIGs) section for more information.