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Are there specific material participation tests for real estate professionals?
Not really. The general seven tests as explained in a separate FAQ are the main factors, but the IRS Audit Technique Guide (ATG) specifically calls out material participation for real estate professionals. Here is the word-for-word copy of that section-
A real estate professional may deduct rental real estate losses only to the extent he or she materially participates in each rental activity. Unless the taxpayer elected to group his rentals as a single activity, each rental is treated as a separate activity. Under the material participation rules, the time of both spouses is counted. The material participation test then applies separately to each individual rental real estate activity. If the taxpayer materially participates in an activity, net income or loss from that activity is non-passive. If the taxpayer does not materially participate, despite being a real estate professional, the rental is passive and losses (or income) go on Form 8582.
A taxpayer, who does most of the work in a rental, meets test #2 for material participation in Income Tax Regs Section 1.469-5T(a)(2). However, if there is on-site management, it may be difficult for the taxpayer to materially participate because:
- 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. In many situations, 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.
- During the initial interview, question the taxpayer regarding time spent in all activities (personal, business, civic, family, hobbies, etc).
- Request and closely examine the taxpayer’s documentation of time utilized for material participation in each activity.
- Look for time spent by others in the activity. Indicators: commissions, management fees, expenses for cleaning, maintenance, repairs, etc.
The notes from the ATG are extremely helpful since it allows the taxpayer to narrow what the IRS is looking for. Knowing someone else’s argument or perspective ahead of time is essential for audit success. See What are some of the IRS tricks to deny my real estate professional designation? below for more insight on how the IRS approaches real estate professionals and material participation.
You can also download the ATG at wcginc.com/ATG-PAL.pdf