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What are the general tests for material participation?
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.
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.
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.
ATG Notes Specific to Real Estate Pros: 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 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 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, the Court in Tax Court Memo 1998-17 (Pohoksi) 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.
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: Noted that the taxpayer did not introduce evidence of the hours spent by a property management company. The 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). Tax Court Memo 1998-17 (Pohoski) 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.
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 (Income Tax Regs 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.
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 Income Tax Regs Section 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. 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 Income Tax Regs Section 1.469-5T(a)(2) holds that performing substantially all the work qualifies for material participation.
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.
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 court involving real estate professionals and rental properties.
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. 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).
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.
If you owned an activity as a limited partner, 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 Tax Court Summary 2012-91 (Chambers) for some real snoozer material.