Material Participation Tests

The IRS conducts several tests to determine if you are a part of an activity that produces income for you. These are called “material participation tests” and include personal service activities such as healthcare, law, engineering, accounting, consulting, and other businesses where capital is not a major income-producing factor. Satisfying one of the seven material participation tests can help you bypass the passive activity loss rules for rental real estate activities. The IRS has seven material participation tests to determine whether a taxpayer participates in an income-producing activity regularly, continuously, and substantially. If the taxpayer passes any of these tests, they can bypass the passive activity loss rules and deduct losses from that activity on their tax return.

How to Pass the Material Participation Test?

To pass a material participation test, you must participate in the activity for at least 100 hours in a year. However, you cannot count the time you spend as an investor in the activity or commuting to and from the activity. You also cannot count the time you spend performing managerial tasks or making major decisions. Also, time spent attending conferences or training does not qualify for material participation.

It is important to remember that if you do not meet a material participation test, your passive activity loss deductions will be limited to your active income. There is one exception, however, for losses incurred in rental real estate activities. The good news is that you only need to pass one of the seven material participation tests each year. You only need to pass ONE of the seven tests to qualify for nonpassive treatment.

Material Participation Test for Farmers

For a farmer to be considered materially participating, he or she must do more than just farm. This can include keeping records, building or repairing fences or buildings used in connection with the production of farm commodities, and providing funds for the payment of taxes on the farm. It can also involve inspecting the farming operations or advising or consulting with the managing party of the business. It can even be a case of using crop-share leases, where the tenant pays a rent, and the landlord provides services. A farmer taxpayer must participate for at least 100 hours in the activity and, based on all facts and evidence, participate regularly, continuously, and substantially. He or she must have participated in the activity for any of the five (not necessarily consecutive) preceding tax years.

Material Participation Test for Real Estate Professionals

Many investors who participate in rental real estate activities struggle with meeting the material participation test requirements. This is because many of these activities generate tax losses. For this reason, they often hire a professional to manage and maintain their properties. But if the professional’s work is considered passive, the investor will not qualify for tax deductions.

One of the easiest ways to meet the material participation test is to be a general partner in an LLC or LLP. This structure offers liability protection and flexibility but is also a great way to avoid passive treatment. The IRS has strict standards for determining who is a general partner, so it’s crucial to keep detailed records.

Another way to avoid passive treatment is to be a “real estate professional.” This designation allows you to deduct all of your rental property expenses, but you must have at least 500 hours of participation. In addition, you must be engaged in the development, renovation, and management of real estate.