Why Active Or Material Participation Matters for Rental Property Income Taxes

Determining your level of involvement is key to the tax treatment of the income/losses that the real estate generates. Real estate, by definition, is a passive investment, but depending on your level of participation you may be able to treat the rental as active or be classified as a “real estate professional” for tax purposes. This allows you to deduct losses the activity generates, or avoid the net investment income tax if the activity generates income. Certain actions and tests are necessary to be eligible. 

First, in any arena, you must meet the material participant requirement from a business activity to make it nonpassive. There are seven ways to do that, any of which can be used by the IRS to determine whether you’ve materially participated. 

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Tests for Material Participation (7 tests, you need to meet 1)

To materially participate in a real property trade or business, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis (IRC Sec. 469(h)(1)). 

Individuals can meet the participation requirements by satisfying one of seven tests determined by the IRS. The tests that measure this according to Temp. Reg. Sec. 1.469-5T(a)(1) are: 

1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for the year;
3. The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for the year;
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the year exceeds 500 hours;
5. The individual materially participated in the activity for any five tax years (whether or not consecutive) during the 10 tax years that immediately precede the tax year;
6. The activity is a personal service activity, and the individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year; or
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

The first three are the ones the majority of real estate investors qualify for.

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Indicators that the taxpayer did not materially participate (Straight from the IRS Technical Audit Guide)

• The taxpayer was not compensated for services. Most individuals do not work significant hours without expecting wage or commissions.
•  The taxpayer's residence is hundreds of miles from the activity.
• The taxpayer has a W-2 wage job requiring 40+ hours a week for which he or she receives significant compensation.
• The taxpayer has numerous other investments, rentals, business activities, or hobbies that absorb significant amounts of time.
• There is paid on-site management/foreman/supervisor and/or employees who provide day-to-day oversight and care of the operations.
• The taxpayer is elderly or has health issues.
• The majority of the hours claimed are for work that does not materially impact operations. 
• Business operations would continue uninterrupted if the taxpayer did not perform the services claimed. 

It’s now a great time to remind you of our simple litmus test to keep you out of trouble: if the day-to-day operations of your real property trade or business and your rentals would be unaffected by the hours you are claiming on your time log, then those logged hours don’t count.

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You must materially participate in each passive activity (each rental property) separately

The taxpayer must materially participate in each passive activity separately. This means if you own 5 rentals, you must show you materially participated in each individual rental activity which can be extremely difficult to do. To get around this, you can make a grouping election under IRS Regs. Sec. 1.469-9(g) but it is highly recommended you speak to a CPA prior to this as the election can have negative long-term consequences.

To get around this issue, we can group all rental activities into one. We then just need to demonstrate material participation in the aggregate. 

The grouping election is found in Regs. Sec. 1.469-9 and requires a formal election statement to be attached to your tax return in the year of making the election. This will group all rentals into one activity for purposes of Section 469. The election is binding for all future years and all future years rental activities are automatically added to the group. 

Proceed with caution though. This grouping election can create problems if you have suspended passive losses. When you sell a property in a group of properties, you may not have disposed of “substantially all” of the activity which will limit your ability to claim losses upon sale.

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Do the material participation requirements change if I’m an LP?

If the taxpayer holds an interest in a real property trade or business through a limited partnership interest, the taxpayer may establish material participation only by satisfying the first, fifth, or sixth tests of the seven tests from above.

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This article is provided for illustrative purposes only; it does not provide personalized tax, legal, financial, or other professional advice. Your situation may be different; consult a professional for information concerning your individual tax, financial, or legal situation before taking any action.