Material Participation- Selection and Acquisition

By Jason Watson, CPA
Posted Saturday. March 21, 2026

Material participation in rental real estate follows a fairly predictable timeline. Investors typically move through four distinct phases: selection and acquisition, pre-opening setup, renovations, and normal operations. The tax code treats each of these phases very differently when counting material participation hours. Some activities clearly count, some clearly do not, and a few sit in a gray area. In the following sections, we walk through each phase of the timeline so you know exactly when your participation clock actually starts ticking.

Research Time Does Not Count

You spent 40 hours surfing Zillow, 10 hours touring duds, and 15 hours analyzing the ROI on a spreadsheet. Do these count toward your material participation hours?

Generally, no.

Whether you are chasing Real Estate Professional Status (REPS), utilizing the short-term rental loophole, or just trying to prove you actively run a side business, you need valid material participation hours. A lot of investors attempt to fill the holes in their timesheets by logging the hours they spend researching new investment properties. While this sounds legitimate to a highly motivated buyer, the IRS and Tax Court consistently deny this position. Find something else to put on your time sheet- cut some grass, hunt and peck your QuickBooks entries, but don’t log Zillow hours.

Investor Time Does Not Count

To understand why this time gets thrown out, we must look at Treasury Regulation Section 1.469-5T(f)(2)(ii) and IRS Publication 925 Passive Activity and At-Risk Rules. Both specifically address work done in an individual’s capacity as an investor.

The rules state that you cannot treat the work you do in an investor capacity as participation unless you are directly involved in the day-to-day management or operations of the activity. Here is a quick blurb-

Work you do as an investor includes:

Studying and reviewing financial statements or reports on operations of the activity,

Preparing or compiling summaries or analyses of the finances or operations of the activity for your own use, and (note the tag line of “for your own use” which might contrast to “tax return preparation use”),

Monitoring the finances or operations of the activity in a non-managerial capacity.

New Business Reality: Operations Versus Assets

If this is your first rental, you generally do not have a business yet. You are just a person with a checkbook and a dream. Because the rental activity generally does not begin until the property is placed in service, none of this initial acquisition and selection time counts toward your material participation.

We must determine when a rental activity starts especially as it relates to material participation. More rules!

Treasury Regulations Section 1.469-1T(e)(3) read-

(3) Rental activity
(i) In general. Except as otherwise provided in this paragraph (e)(3), an activity is a rental activity for a taxable year if—

(A) During such taxable year, tangible property held in connection with the activity is used by customers or held for use by customers; and

(B) The gross income attributable to the conduct of the activity during such taxable year represents (or, in the case of an activity in which property is held for use by customers, the expected gross income from the conduct of the activity will represent) amounts paid or to be paid principally for the use of such tangible property (without regard to whether the use of the property by customers is pursuant to a lease or pursuant to a service contract or other arrangement that is not denominated a lease).

Did you read each word? Ah, you’re better for it if you did. What all this nonsense is saying is that you must have a rental property “used by customers or held for use by customer” for your activity to be a rental activity. In other words, you need an asset, the rental property, to be placed in service. Treasury Regulations Section 1.167(a)-11(e)(1)(i) define “placed in service,” and can be summarized as ready and available for occupancy, and held out for rental use through advertising and related efforts.

But there is another wrinkle to all this. Short-term rentals with average guest stay of 7 days or less are not considered rental activities. Huh? Why does this matter?

Let’s go to the regulations! Treasury Regulations Section 1.469-4, titled “Definition of an activity,” reads in part-

(b) Definitions. The following definitions apply for purposes of this section—

(1) Trade or business activities. Trade or business activities are activities, other than rental activities or activities that are treated under § 1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment, that—

(i) Involve the conduct of a trade or business (within the meaning of section 162);

(ii) Are conducted in anticipation of the commencement of a trade or business; or

(iii) Involve research or experimental expenditures that are deductible under section 174 (or would be deductible if the taxpayer adopted the method described in section 174(a)).

What does this mean? You are considered to have an activity by the mere anticipation of the commencement of a trade or business that is not a rental activity. Therefore, since a short-term rental is not considered a rental activity, you nonetheless have an activity that you can materially participate in without necessarily having the asset (e.g., the rental property) placed in service.

To understand why the IRS is so strict about this, it helps to compare real estate to a traditional business.

Imagine you wake up on a Monday and decide to start a business selling used copiers. Your bartender says there’s big money in that, and you drop your W-2 job and start thinking about toner.

You spend the next three months reading repair manuals, attending trade shows, designing business cards, building a website, procuring inventory, negotiating contracts, creating marketing materials, hiring a staff or support team of contractors, buying office furniture and equipment, deploying an accounting system, among the myriad of other things business owners do, you are materially participating in your used copier activity.

Assuming your marriage survives, and you actually open your doors and start selling copiers that same year, the time you spent building the framework of that business is generally viewed as active participation in your new trade or business. You are building an operation.

Real estate is different. When you buy a rental property, the asset is the activity. When you spend three months scrolling Zillow, driving through neighborhoods, and running ROI spreadsheets, you are not building an operation; you are shopping for an asset. The IRS views this through a completely different lens. They see you acting strictly as an investor looking for a place to park your capital.

Subtle difference. And one you unequivocally don’t like.

As we discussed earlier, the tax code explicitly excludes investor time from counting toward material participation unless you are involved in the day-to-day management. Since you don’t own the property yet, there is no day-to-day management to be had. In short:

• Traditional Business. Pre-opening work (like building a website or marketing) can often be tied to the active operational framework of the business once it launches.
• Rental Real Estate. Pre-purchase work (like Zillow surfing and running numbers) is almost always classified as excluded investor time.

Yes, there is a bit of a chicken or the egg conundrum with real estate and material participation during the early stages. Think of it this way- if the rental property is not placed in service (ready and available for rent), there is nothing to report on a tax return.

If we go back to the investor hours do not count issue, the IRS can have it both ways- they can say the activity hasn’t started yet, so your hours disappear into the ether, and if you argue the activity has started without a place in service asset, the IRS can call your hours investor hours.

Let’s pile on, shall we? Tax Court decisions tend to reinforce this same distinction. When evaluating material participation in rental real estate, courts consistently focus on operational work such as supervising repairs, dealing with tenants, advertising vacancies, negotiating leases, and coordinating maintenance. By contrast, time spent analyzing potential investments, reviewing market data, or searching for new properties is routinely treated as investor activity rather than participation in the rental operation.

Expense Deductions Versus Material Participation Hours

You might also notice another confusing overlap here: deductible expenses versus participation hours. Just because an expense is deductible does not mean the time associated with it counts toward material participation.

For example, if you already own a rental property in Austin and travel across town to evaluate another potential rental in the same market, you might be able to deduct certain travel costs as part of your existing rental activity. The expense may qualify as an ordinary and necessary business cost, or it might be capitalized as an acquisition cost if you ultimately purchase the property.

However, that does not mean the hours spent analyzing that potential purchase count toward material participation. Yeah, we know, it stinks.

The tax code treats these issues completely separately. Expense deductions and capitalization principles are governed by rules such as IRC Section 162 and Section 212, while material participation is governed by the passive activity rules under IRC Section 469. Passing one test does not automatically satisfy the other.

To make a long story even longer, an expense deduction does not magically convert investor time into participation hours. Sorry. The good news is that almost everyone conflates these two, so if you did too, you are not alone. Support group. Jackets. We got you.

The Hailstock Unicorn (A Rare Exception)

However, in Hailstock v. Commissioner, Tax Court Memo 2016-146, the rental property owner did not keep a log with specific hours. It might have actually helped since the Tax Court accepted her narrative testimony plus her massive array of rental properties as enough evidence to demonstrate 750 hours of participation for real estate professional status. The case reads in part-

We find petitioner’s narrative summary convincing because she owned numerous rental properties and conducted her business as a “one-man operation” without being otherwise employed. As previously discussed, petitioner spent well in excess of 40 hours each week doing work related to numerous rental properties (i.e., researching prospective properties, maintaining properties, supervising work orders, finding tenants, securing leases, and continuing education related to rental real estate).

This was a win, but it should not be construed as a green light to log research and continuing education hours. In Hailstock, the taxpayer had well over twenty properties, she was not otherwise employed, and real estate was the only thing she spent time on. Her sheer volume of activity and lack of a W-2 job saved her. Do not build a tax strategy around being the exception to the rule. See our discussion on time logs on page 277.

The Expansion Exception

If you are not a full-time real estate professional with 20 properties, there is one other way acquisition time might count: if you already own rentals and treat the new purchase as an expansion of an existing activity rather than the start-up of a new one.

To do this, you must legally group your rentals as a single “appropriate economic unit” on your tax return using Treasury Regulations Section 1.469-4 election. By default, the IRS treats every rental as a separate activity. If they aren’t grouped, the new property is a standalone venture, and its pre-opening clock is stuck at zero.

But be careful! The IRS looks closely at similarities in trade and geographic location. If you own a rental in Austin and buy another on the same street, managing the acquisition could reasonably be considered operational work for your existing Austin rental business.

But what if you own a rental in Austin and start shopping for one in Orlando? The IRS heavily presumes that real estate in a new geographic market is a completely new business venture, not an expansion. They argue that a new city means different market dynamics, local laws, and management teams. While you can sometimes fight this by proving you run everything through a centralized, master management structure, it is an uphill battle.

Even if you successfully use the expansion argument (and even if you group the properties) pure investor tasks like financial analysis still never count. Only the business tasks of the acquisition might sneak in under the expansion umbrella.

Real Estate Professional Status 750 Hours Exception

Time spent acquiring a rental property is generally suspect for material participation purposes, as we’ve discussed. However, some of that time might still count toward the 750-hour test for real estate professional status.

Let’s review IRC Section 469(c)(7)(C) again for fun-

For purposes of this paragraph, the term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

However, it is important to understand the broader umbrella of IRC Section 469. The section is titled “Passive activity losses and credits limited.” It is not primarily about material participation. Having said that, IRC Section 469 does discuss material participation to determine if an activity is passive or nonpassive. Specifically, IRC Section 469(h) reads-

(h) Material participation defined
For purposes of this section-

(1) In general a taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is-

(A) regular,
(B) continuous, and
(C) substantial.

What are we getting at here? It is easy to throw all of this into a material participation, passive activity, and real estate professional status stew and assume that the word “acquisition” somehow connects directly to material participation. It does not.

Rather, your hours might count toward the 750-hour real estate professional test, but not toward material participation for a specific rental activity until that activity actually exists. In other words, the hours you spend building your 750-hour total do not automatically count toward material participation in a particular property.

In other words, the same hour might help you qualify as a real estate professional but still fail to count toward material participation in a specific rental property.

Sidebar: Even though we just discussed this a few paragraphs ago, it bears repeating to solve this acquisition conundrum. The tax code loves a good general rule followed by a narrow exception. While not needed for the 750 hours test, grouping elections can certainly help on material participation.