What Is a Material Participation Test?

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DEFINITION
A material participation test is one of seven tests that determine whether a taxpayer is sufficiently involved in an activity for it to not be considered a passive activity for federal income tax purposes.

A material participation test is one of the tests used to determine whether a taxpayer materially participates in a certain activity, which allows the taxpayer to bypass the passive activity rules under certain circumstances.

Definition and Example of a Material Participation Test

A material participation test is one of seven tests that determine whether a taxpayer is sufficiently involved in an activity for it to not be considered a passive activity for federal income tax purposes.

For example, one of the seven material participation tests is whether a taxpayer has participated in an activity for more than 500 hours during the year. So if a taxpayer participates in an activity for 600 hours during the year, they are considered to have materially participated in the activity for the year.

How Material Participation Tests Work

Taxpayers are limited in their ability to deduct losses they incur in a trade, business, or a real estate activity. They are limited first by the basis, excess farm loss, and at-risk rules, then, potentially, by passive activity rules.

Generally, if a taxpayer’s activity is subject to the passive activity loss rules, they will not be permitted to deduct any loss from that activity on their tax return. Instead, that loss is considered a passive activity loss that is disallowed in the current year and is carried forward to future tax years.

Material participation tests are key factors in determining whether a taxpayer’s activity is subject to the passive activity rules.

How Material Participation Tests Work for Trade or Business Activities

In general, a taxpayer’s trade or business activity is passive and their losses in that trade or business are limited by the passive activity rules, unless the taxpayer materially participates in that activity by satisfying any one of the seven material participation tests, which we'll review in more detail below.

How Material Participation Tests Work for a Real Estate Activity

The passive activity rules work a bit differently for real estate activities.

To bypass the passive activity rules for a rental activity, a taxpayer must materially participate in the activity. They must also qualify as a real estate professional for the year.

In general, to qualify as a real estate professional for a given year, a taxpayer must perform more than 750 hours of services in real estate activities in which they materially participate. More than half of the hours they spent on personal services during the year must have been performed in these activities.

However, even if a rental activity is a passive activity, a taxpayer may still deduct up to $25,000 in losses in rental activities that they actively–not necessarily materially–participated in during the year as a special allowance.

Active participation has a lighter standard than material participation. In general, a taxpayer is considered to have actively participated in an activity if they own at least 10% of the activity and make management decisions for the activity.

The amount of the $25,000 special allowance is reduced by 50% of the modified adjusted gross income that exceeds $100,000. So once a taxpayer’s modified adjusted gross income reaches $150,000, they can’t utilize this special allowance at all.

Separate rules for the special $25,000 allowance apply for those who are married but file separately from their spouse. For example, your special allowance can’t be more than $12,500.

Types of Material Participation Tests

There are seven material participation tests. If a taxpayer satisfies any one of these tests for a trade or business activity, they are not subject to the passive activity rules for that activity for the year.

If a taxpayer satisfies any one of these tests for a rental real estate activity and the taxpayer also qualifies as a real estate professional for the year, the activity is not subject to the passive activity rules for the year.

The seven IRS material participation tests are listed below. Note that as long as a taxpayer meets one of these tests for a given activity, they are considered to have materially participated in that activity for the year.

  1. The taxpayer participated in the activity for more than 500 hours during the year.
  2. The taxpayer’s participation in the activity constituted a substantial part of all the participation in the activity during the year.
  3. The taxpayer participated in the activity for more than 100 hours during the year and participated in the activity at least as much as any other individual.
  4. The taxpayer participated in multiple activities for more than 100 hours each during the year, but their participation in each of these activities, viewed in isolation, did not rise to the level of material participation. However, the taxpayer’s participation in all such activities, when combined, exceeded 500 hours. These kinds of activities are known as significant participation activities.
  5. The taxpayer materially participated in the activity for any five of the previous 10 years, and they qualified for material participation in the activity by any of the tests other than by participation in the activity for any five of the previous 10 years.
  6. The taxpayer materially participated in the activity for any three of the previous 10 years, and the activity is a personal service activity. A personal service activity, in general, is an activity that involves the taxpayer’s personal time and effort, and in which capital is not a major income-producing factor.
  7. The taxpayer participated in the activity on a regular, continuous, and substantial basis.

The IRS has some guidelines in place to avoid abuse. For example, to meet test number 7, the taxpayer must have participated in the activity for more than 100 hours during the year.

Also, if the taxpayer manages others in the activity, the taxpayer’s time spent managing the activity doesn’t count toward this 100-hour test if there was another compensated manager for the activity during the year, or if someone else spent more time managing the activity than the taxpayer did, regardless of the manager’s compensation.

Many of these tests are based on the taxpayer working a certain number of hours in the activity, so taxpayers should maintain some records of their participation in an activity.

The record-keeping standards for purposes of verifying one’s material participation in an activity are not as stringent as those for, say, a mileage log. However, taxpayers should be able to produce some written evidence that would satisfy a reasonable third party that they participated in the activity to the extent they claimed they did.

Note that when determining whether a taxpayer materially participates in an activity, they may include their spouse’s participation in the activity, even if they don’t file jointly.

Finally, unless a taxpayer is involved in the day-to-day management or operations of an activity, they may not count their time spent performing tasks that an investor in an activity would typically perform, such as reviewing financial statements.

Key Takeaways

  • A material participation test is a test that when completed by a taxpayer for a given activity, allows the taxpayer to bypass the passive activity rules under certain circumstances.
  • To avoid being subjected to the passive activity rules, a taxpayer must materially participate in that activity and qualify as a real estate professional for the year.
  • There are seven material participation tests, many of which set standards for the number of hours the taxpayer must have participated in the activity.

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