What Is Material Participation?

Material participation and Active participation are two essential concepts to understand regarding passive activity loss rules (PAL). These terms help determine the tax treatment of losses and credits generated from various activities, notably businesses and rental properties.

Material Participation refers to a taxpayer’s involvement in the day-to-day operations and decision-making of a business venture. A taxpayer is considered to be materially participating if they meet at least one of the following tests annually:

1. 500-hour Participation: The taxpayer participates in the activity for at least 500 hours during the tax year. This is the most straightforward test, as it solely relies on the number of hours dedicated to the business.
2. Primary participant: The taxpayer’s involvement in the activity is more substantial than any other individual during the tax year. In other words, they must have participated in managing the business more than anyone else.
3. 100-hour Participation and no one more: The taxpayer participates in the activity for at least 100 hours during the tax year, and no one else, including non-owners, participates more hours than the taxpayer.
4. Significant Participation and 500-hour total: The taxpayer significantly participates in the activity for at least 100 hours during the tax year, and their total Participation in all significant participation activities is more than 500 hours.
5. Material Participation in past years: The taxpayer materially participated in the activity in any 5 of the 10 preceding tax years.
6. Personal service activity: If the activity is a personal service activity such as law, accounting, or consulting, the taxpayer materially participated for any 3 prior tax years.
7. Facts and Circumstances: If a taxpayer fails to meet any of the previous six tests but wants to claim material Participation, they may provide facts and circumstances to demonstrate their involvement. This would require at least 100 hours of Participation in the activity during the tax year and must prove that their Participation was regular, continuous, and substantial.

What Is Active Participation?

Active Participation relates explicitly to the real estate industry. A taxpayer is considered actively participating in a rental property if they have made management decisions or arranged for someone else to provide services such as repairs, rent collection, and tenant selection.

Active Participation allows taxpayers to deduct up to $25,000 of rental losses against their non-passive income.

What Is a Trade or Business Activity?

Trade or business activities refer to enterprises that individuals might engage in to earn income or profit. To classify an activity as a trade or business, the taxpayer must materially participate in it.

In general, material Participation helps to distinguish between active and passive income for tax purposes.

What Are Rental Real Estate Activities?

As the name suggests, rental real estate activities involve renting out residential or commercial property. These activities, too, can generate either active or passive income, depending on the taxpayer’s level of involvement.

In most cases, rental real estate activities are considered passive, even if the taxpayer materially participates in them.

However, there’s an exception: if the taxpayer qualifies as a real estate professional (explained in the next section), their rental real estate activities in which they materially participate are not considered passive.

Real Estate Professionals and Passive Activity Loss

Real estate professionals can avoid some limitations imposed by the passive activity loss rules. To qualify as a real estate professional, a taxpayer must meet specific requirements outlined in the Internal Revenue Code (IRC) Secs. 469(a), (c)(2), and (c)(7).

A taxpayer must fulfill two main criteria to be considered a real estate professional (REPS):

• More than 50% of the taxpayer’s personal service time during the tax year must be spent on real property, trade, or business activities in which they materially participate.
• The taxpayer must spend more than 750 hours per year on these activities.

Some key points about real estate professionals and passive activity loss include:

• Being a real estate professional does not automatically guarantee that rental losses can be offset against nonpassive income. A taxpayer still needs to establish material participation in each rental activity.
• Making an election to group all rental real estate activities under one activity simplifies material participation determination and provides greater tax benefits in offsetting nonpassive income.

Suppose you’re a doctor or other high-income earner and obtain REPS status. In that case, you’re able to offset rental losses against nonpassive income and potentially achieve significant tax savings.

Applicable Tax Forms and Filing Requirements

When filing taxes and accounting for passive activity loss rules, several forms are crucial for reporting income, gains, and losses. These forms include Forms 8582, Form 8582-CR, and IRS Form 6198.

Form 8582: Passive Activity Loss Limitations

Form 8582 is used by individual taxpayers, estates, and trusts with passive activity losses to calculate and limit the allowable passive activity loss for the tax year. This form helps to ensure compliance with Section 469 of the Internal Revenue Code. Taxpayers should complete Form 8582 if they:

• Have a passive activity loss from any rental real estate activity, trade, or business.
• Have any prior-year unallowed passive activity losses?

Form 8582-CR: Passive Activity Credit Limitations

Form 8582-CR calculates and limits the amount of passive activity credits that can be used in the current tax year. Taxpayers with passive activity credits from rental real estate or business activities where they do not materially participate must complete this form.

IRS Form 6198: At-Risk Limitations

In addition to the passive activity loss rules, taxpayers may need to file IRS Form 6198 for at-risk activity limitations. This form is used when a taxpayer has a loss from an activity they are engaged in as a trade or business or for the production of income and is considered at-risk.

The at-risk rules apply to individuals, estates, trusts, and certain closely held C corporations. If a taxpayer is required to file Form 6198, they must also file Form 8582 to account for passive activity limitations.

Entities Subject to Passive Activity Loss Rules

Individuals

Individuals are subject to passive activity loss rules. These rules prohibit using passive losses to offset earned or ordinary income. For individuals, the rules apply to activities such as rental properties and investments in limited partnerships. Taxpayers can only offset passive income with passive losses from the same activity or other passive activities.

Estates and Trusts

Estates and trusts are also subject to the passive activity loss rules. The rules are similar to those applied to individuals, meaning that passive losses generated by estates and trusts can only be used to offset passive income from the same or other passive activities.

Limited Partnerships and Personal Service Corporations

Limited partnerships and personal service corporations (PSCs) fall under the scope of passive activity loss rules. Limited partners generally have their losses and income categorized as passive, irrespective of their involvement in activities. Similarly, personal service corporations, which provide services in fields such as law, engineering, health, and accounting, face passive activity loss restrictions.

Closely Held Corporations

Closely held corporations are subject to passive activity loss rules as well. These corporations have a limited number of shareholders, and their stock is not publicly traded. In such cases, passive losses can only be used to offset passive income. A closely held corporation can only use passive activity losses to offset passive income; it cannot use passive losses to reduce the corporation’s net active income.

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