Material participation is a key concept for real estate investors. In certain cases such as Real Estate Professional Status and in short-term rentals, It determines whether you can deduct the losses from the activity against other income, or whether the losses are subject to the passive activity loss rules.
How do you meet the tests of Material Participation?
Material participation occurs when you are involved in an activity on a regular, continuous, and substantial basis. The IRS has set up seven tests in which you must meet one to prove that you materially participated in the activity. These tests generally measure the amount and nature of the your involvement in the activity during the year. The most common test is to participate in the activity for more than 100 hours in the year and no one else performs more hours than you. The second most common test is to participate in the activity for more than 500 hours in the year. This test can be difficult to achieve unless you have a portfolio of properties and elect to aggregate them as one activity.
What Activities count towards Material Participation?
Not all activities count as participation for this purpose. The IRS has specified some activities that are excluded from participation. These activities include:
– Travel to and from the activity
– Education or research related to the activity
– Investor activities, such as reviewing financial statements, preparing summaries, or monitoring the finances of the activity
These activities are excluded because they are not considered to be directly related to the day-to-day operations or management of the activity. They are more like activities that a passive investor would perform, rather than an owner or operator.
The bottom line
Therefore, if you want to achieve material participation in an activity, you need to make sure that you are involved in the actual running of the activity, and not just in peripheral or ancillary tasks. You also need to keep track of your hours and document your participation, as the IRS may ask for proof if you claim a loss from the activity.