Material Participation Rules

By Jason Watson, CPA
Posted Saturday, August 10 2024

Material participation is one the most scrutinized and talked about topics among real estate investors and rental property owners. The two most common conversations is either about real estate professional status (REPS) or the short-term rental (STR) loophole. When we get into the meat of Temporary Treasury Regulations 1.469-5T, we will add some light commentary about each test. We dig a bit further in our respective sections on real estate professionals and short-term rentals.

Active Participation

Let’s discuss active participation first. For rental properties, the issue is nearly moot since active participation relates only to rental real estate activities and is a less stringent standard than material participation. As long as a taxpayer participates in management decisions in a bona fide sense, they actively participated in the real estate rental activity. Activities include new tenant approval, rental terms, repair authorizations, capital expenditures, etc. WCG CPAs & Advisors has a client whose brother handles all the rental property matters for a condo in San Francisco- in this example, his participation did not reach the level of active participation. Said differently, if you forget that you own a rental property because others are handling the business, you likely do not actively participate.

According to the IRS Audit Techniques Guide on Passive Activities there is not a specific hour requirement. Even if you use a management company, you will be considered active if you are involved with the operation of your rental. However, you must be exercising independent judgment and not simply ratifying decisions made by a manager or management company. In addition, you must have at least a 10% interest in the rental activity.

Passive Activity Loss Limits

To recap for married taxpayers, passive activities such a rentals or investment partnerships have a loss limit of $25,000 in offsetting non-passive income such as W-2 wages or other earnings. This is reduced by $1 for every $2 over $100,000 in modified adjusted gross income (MAGI). Any disallowed passive loss is carried forward until you have offsetting passive income, or you sell the rental property. For example, you make $120,000 at your regular job and have $30,000 in rental losses. Your passive loss deduction is $15,000 ($25,000 minus $10,000) and the remaining $15,000 is carried forward.

Material Participation Audit Tests

Ok. Here we go. This is where the IRS is starting to crack down on what they deem gaming the system by self- determined real estate professionals and short-term rental loopers (yeah, we just made up the word looper, but it has a nice ring). IRC Section 469(h)(1) reads-

(h) Material participation define
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.

Keep in mind that this is the Internal Revenue Code or the IRC. Treasury Regulations attempt to take the IRC and provide context including examples.

What the heck is regular, continuous and substantial? Temporary Treasury Regulations 1.469-5T(a) gives us a hand. There are several requirements for material participation, and satisfaction of any one test will allow you to be considered materially participating. We’ll discuss each one in turn and refer to notes from the IRS Audit Techniques Guide (ATG) for each test including case law when applicable.

As you read these, also keep in mind that the IRC simple states “regular, continuous and substantial.” The seven tests for material participation (only six since the seventh is the catch-all facts and circumstances test) can be considered a safe harbor of sorts or a bright line. The IRS basically says, “hey, prove X and we won’t challenge the materiality of your participation. If not, bring all your data to us, pack a lunch and a snack, and let’s chat.”

1. You participated in the activity for more than 500 hours.

ATG Notes: If the taxpayer participates more than 500 hours during the year in a business, income or loss from the activity will be non-passive. Participation of both spouses is counted, but not participation of the children or employees. Participation in operations must be regular, continuous, and substantial. The examiner should determine whether the quantity of time documented is reasonable in light of other obligations.

What exactly does “regular, continuous, and substantial” mean? No definition is provided in the Internal Revenue Code or other regulations. However, among Technical Advice Memorandums (TAMs) and tax court Cases, a general notion exists that for a taxpayer to materially participate, the taxpayer must be involved in the day-to-day management and operations of the rental activity (similar to a trade or business).

ATG Notes Specific to Real Estate Professionals: Rental activities, by nature, normally do not require significant day- to-day involvement, i.e. they are not time intensive. For many taxpayers using any kind of outside management, the only material participation test available is the 500 hour test- the other tests will not apply. In many circumstances, an individual rental activity will not require 500 hours of participation, nor will the taxpayer have sufficient time available to spend 500 hours on each individual rental real estate activity.

Examination Techniques: Review W-2s and other non-passive activities. Does it seem likely that the taxpayer claiming to be a real estate professional could spend 500 hours on the activity in light of other employment obligations? Ask questions on taxpayer material participation activity time early in the examination. Establish the time the taxpayer spends on all activities during the initial interview if possible. Determine the location of each activity. If located far from the taxpayer’s residence, how likely is the taxpayer to have spent substantial time on the activity?

Tax Court: Despite the IRS’s ATG notes on passive activities, the tax court in Pohoksi v. Commissioner, Tax Court Memo 1998-17 implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a property management company. This is a satisfaction of test #2.

WCG Notes: This is basically 10 hours a week, every week. Even a short-term rental usually has down time between seasons or events. A normal work year is 2,080 hours and 500 hours is basically 25%. We are not saying 500 hours is inconceivable or indefensible, but adding some comparison data helps the perspective.

2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.

ATG Notes: Stated simply, if the taxpayer does most of the work, income or loss will be non-passive. The involvement in the activity of an employee or non-owner could cause the taxpayer to fail this test. There is no specific number of hours associated with this test. In addition, the term “substantially” is not defined in the regulations.

Tax Court: In Pohoski, the tax court noted that the taxpayer did not introduce evidence of the hours spent by a property management company. The tax court implied that they would entertain proof that the taxpayer substantially participated as compared to the participation of a third party (in this case a management company). Pohoski v. Commissioner, Tax Court Memo 1998-17 stated the second test was not satisfied when taxpayers failed “to put forth some indication of the actual time spent by” third-party non-owners in activities on the property.

WCG Notes: This test is critical for partial year rental property activities especially when considered accelerated depreciation deduction from a cost segregation study. If you buy a rental and place it into service on October 1, the hours in test #1 above and test #3 below are not pro-rated for the partial year. The hours threshold is strict.

3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.

ATG Notes: If a taxpayer participates in an activity for more than 100 hours and no other individual participates more than the taxpayer (including any employee or non-owner), income or losses from the activity are non-passive.

Examination Techniques: Be alert to employees who are managing the activity, indicating the taxpayer deducting the losses may not be materially participating (particularly on Form 1040 Schedules C and F). When reviewing taxpayer hours, watch for “investor” activities (Internal Revenue Code Section 1.469-5T(f)(2)(ii)). The taxpayer must be involved in the activity’s day-to-day management or operations. Hours spent toward reviewing financial statements, preparing analysis for personal use, and monitoring the activity in a non-managerial capacity do not count.

WCG Notes: We will discuss what time counts in a bit. The ATG mentions investor activities, and this is a common area where real estate investors and rental property owners get tripped up. Test #3 is a class favorite for the short-term rental (STR) loophole. However, you must track the time of cleaners and maintenance personnel.

4. The activity is a significant participation activity (SPA), and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.

ATG Notes: The term significant participation activity is unique to Internal Revenue Code 1.469-5T. If the sum of the taxpayer’s time in all SPAs is more than 500 hours for the year, then income or losses from the businesses are non-passive and the taxpayer might be considered a real estate professional. For each SPA, the regulations require: The taxpayer to participate more than 100 hours during the year. The activity must be a business, i.e. it cannot be a rental or investment activity. The business must be a passive activity. Thus, if the taxpayer works more than 500 hours in the business, it is not a SPA as 500 hours is one of the qualifying tests for material participation. Similarly, if the taxpayer does most of the work in the business, it cannot be a SPA as Internal Revenue Code Section 1.469-5T(a)(2) holds that performing substantially all the work qualifies for material participation.

WCG Notes: Yawn.

5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.

ATG Notes: An activity is non-passive if the taxpayer would have been treated as materially participating in any 5 of the previous 10 years (whether or not consecutive). This test usually applies when a taxpayer “retires from material participation” but maintains an ownership interest in the activity.

Examination Techniques: Even if the taxpayer performs no services for a business currently, the examiner should inquire about involvement in prior years and review the returns to see if income or losses were treated as non-passive.

WCG Notes: We discussed this in an earlier section on considering your small business as a passive income activity. Test #5 is a pariah of sorts since it is what the IRS uses to deem your activity non-passive when you are wanting passive activity income. Test #1, #2 and #3 are the common ones to prove the activity is non-passive. The sword cuts both ways.

6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

ATG Notes: None.

Examination Techniques: None.

Tax Court: As far as we can tell, this test has not been used in tax courts involving real estate professionals and rental properties.

WCG Notes: Some real estate investors and tax strategists have argued that operating rental properties is a personal service. We disagree. The personal services listed in this test are traditional service professions where you would have clients or patients. Of course, an argument could be made that tenants are clients, but the one hiccup is the rental property itself. The personal service would not exist if it wasn’t for the building, therefore capital is a material income-producing factor (income comes from rents, rents come from tenants, tenants live in buildings, buildings require capital for acquisition).

Said in another way, the personal service is being spent on the building (maintenance, approving who gets to use it, recording transactions regarding the building, etc.) rather than on a person. Therefore, it is not truly a personal service. Personal service has the word person in it to boot! Also, doesn’t #6 look eerily similar to the rules in Section 199A qualified business income deduction? We digress.

7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

ATG Notes: The facts and circumstances test may apply if none of the other tests are met. This test does not apply unless the taxpayer worked more than 100 hours a year. Furthermore, the taxpayer’s time spent managing will not count if: Any person received compensation for managing the activity and any person spent more hours than the taxpayer managing the activity.

Examination Techniques: Taxpayers may argue the facts and circumstances test when they fail the others. However, due to the stringent limitations, few taxpayers can meet the facts and circumstances standard. If there is paid on-site management, the facts and circumstances test cannot be used.

WCG Notes: Recall that the IRC Section 469 is the actual law which reads “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.” As we’ve stated before, material participation tests #1 through #6 can be considered a safe harbor of sorts or a bright line. If you cannot easily fit into one of those, then you have to prove you case with data, solid recordkeeping and some luck.

LLC Members

If you owned an activity as a limited partner or member, you generally are not treated as materially participating in the activity. However, you are treated as materially participating in the activity if you met test #1, #5 or #6 described above. You can also see Chambers v. Commissioner, Tax Court Summary 2012-91 for some real snoozer material.

Fundamental Underpinnings of the Code

As a reminder, and as stated elsewhere, the Internal Revenue Code is trying to say that if you meet one of the material participation rules, then the activity is automagically deemed to be “business-like.” While so many people warn against the “facts and circumstances” argument, we must remind ourselves of the underpinnings of determining material participation- , is this some side-gig hobby-esque passive whatever whatever, or is this a real business with a real vision and commercial substance?

We dig a little deeper and apply material participation tests in our sections on real estate professional status (REPS) and short-term rental (STR) loophole.