What Does ‘Material Participation’ Mean?

When a real estate investor becomes a landlord, they often look into tax breaks associated with owning rental property.

There are many tax breaks associated with owning rental real estate. Ordinary expenses like insurance, property taxes, and repairs can be deducted in the same year incurred.

Larger improvements are “capitalized” and “depreciated” over a long period of time.

But if you do enough research and talk to knowledgeable CPAs, you’ll eventually run across the terms “real estate professional status” and “material participation.”

Understanding real estate professional status and material participation will allow you to maximize tax opportunities that come from owning rental real estate.

These concepts are THE holy grail for landlords.

In today’s article, I’m going to explore material participation with you. We’ll explore real estate professional status in a future article.

Why Should You Care?

IRC Sec. 469 defines two types of activities: passive and non-passive. Every dollar that you earn will fall into one of these two buckets.

Passive activities are those that don’t require much effort from you. Non-passive activities are those that you are actively working on to make money.

Sec. 469(c) formally defines this for us. A passive activity is any activity:

1. Which involves the conduct of any trade or business in which the taxpayer does not materially participate.
2. Any rental activity, unless the taxpayer qualifies as a real estate professional.

Most landlords hold rentals that generate tax losses after depreciation. Those tax losses are “passive” and cannot offset “non-passive” income (such as W-2 or business income).

Passive losses in excess of passive income are suspended and carried forward.

If, however, a rental loss is converted into a non-passive loss, it can offset W-2 and business income.

In an ideal world, a landlord will qualify as a real estate professional (test #2 above) AND materially participate in their rentals (test #1 above) in order to classify the tax losses from their rentals as non-passive (Perez v. Commissioner, T.C. Memo 2010-232).

Short-term rentals offer an exception in that you can skip the “real estate professional” test and move directly to the “material participation” test. Check out an earlier article we wrote for a discussion as to why this is the case.

What is Material Participation?

The two important phrases from the above paragraph that I want to draw your attention to are:

• Real estate professional
• Material participation

Because again, if a landlord is a real estate professional AND materially participates in their rental activity, then the rental loss will be non-passive.

To qualify as a real estate professional a taxpayer must spend (1) 750 hours materially participating in real property trades or businesses; and (2) more time in those trades or businesses than any other activity.

Check out this resource for a full explanation on real estate professional status.

Even in the real estate professional definition we see the words “materially participating.”

It’s an important concept to understand because with material participation, our rentals may be non-passive. Without it, our rentals are passive.

We generally want rentals to be non-passive to optimize our tax position.

So what does it mean to “materially participate?”

At a high level, you must be involved in the operations of the activity on a regular, continuous, and substantial basis (IRC Sec. 469(h)(1)). 

The Regs. define this further by offering seven tests to demonstrate material participation (Temp. Reg. Sec. 1.469-5T(a)(1)).

You must only meet one of the below seven tests and you must own a 5% stake in the employer for your hours to count.

The first three are the tests our clients at The Real Estate CPA most often meet:

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

As you can see, material participation is all about the amount of hours you spend working in your business or rental portfolio.

What Hours Count and Don’t Count?

Many investors want to hear that hours spent on education, listening to podcasts, networking, and travel count as material participation hours.

Why? Because those hours are relatively easy to log.

Unfortunately, the IRS and Tax Court have consistently taken the position over the past two decades that if you are spending time on activities that are not integral to the day-to-day operations of your rental properties, then the hours don’t count.

This means education and research hours don’t count. It also means travel* time doesn’t count. The following is a list of Tax Court cases backing this position up:

• Education & Research: Jafarpour v. Commissioner, T.C. Memo 2012-165
• Education & Research: Padilla v. Commissioner, T.C. Summary Opinion 2015-38
• Education & Research: Levitz v. Commissioner, T.C. Summary Opinion 2018-10
• Travel: Thomas E. Truskowsky, T.C. Summary Opinion 2003-130
• Travel: Lucero v. Commissioner, T.C. Memo 2020-136

*Travel time could count if your “travel” really means that you are visiting your properties multiple times a week and they are local to you. See Leyh v. Commissioner, T.C. Summ. 2015-27 for guidance.

“Investor hours” also don’t count unless you are involved in the day-to-day operations. Specific investor-related activities include:

• Studying and reviewing financial statements or reports on operations of the activity
• Preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use
• Monitoring the finances or operations of the activity in a non-managerial capacity

The relevant Tax Court cases where investor hours were denied as counting toward material participation are:

• W.A. Barniskis, 78 T.C. Memo 226, December 53,486(M), TC Memo 1999-258
• Padilla v. Commissioner, T.C. Summary Opinion 2015-38
• Jafarpour v. Commissioner, T.C. Memo 2012-165
• Hairston v. Commissioner, T.C. Memo 2019-104
• Walter A. Barniskis, et ux., v. Commissioner, T.C. Memo 1999-258

You just learned that investor, education, research, and most travel hours do not count toward the material participation tests.

So what hours DO count? How can you log 500 hours of material participation, or 100 hours and more than anyone else?

Participation hours in real property trades or businesses in which you materially participate are those that affect the day-to-day operations of the business. 

Examples of such hours include:

• Hours spent acquiring property (not research hours!), 
• Showing the property to prospective tenants, 
• Writing and placing rental ads
• Taking tenant applications
• Running background checks and screening tenants
• Preparing and negotiating leases
• Cleaning the units after tenant move-out
• Maintaining the grounds
• Doing repairs yourself
• Doing improvements yourself or arranging (and managing, but not “watching”) others to do them
• Hiring and supervising a property manager
• Purchasing supplies and materials for use on the rentals
• Inspecting the property
• Communicating with tenants, responding to their complaints
• Collecting rents
• Evicting tenants
• Traveling to your rentals (as long as there is a business reason to do so)

What do those tasks sound like? Property management duties.

So if you’re reading this and thinking “dang I have to self-manage my rentals to qualify” you are certainly on the right track.

To take it one step further, I’ve developed a simple litmus test that you can apply: 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.

Important point #1
If you have a management company that maintains your rentals and collects rent, you’re going to have a tougher time demonstrating material participation.

This is because test #2 (substantially all) of the seven tests I listed above is now unachievable due to the property manager performing substantially all of the work.

Additionally, test #3 (100 hours and more than anyone else) will be tough to substantiate. 

Important point #2
A married couple filing jointly cannot combine hours for the purposes of the real estate professional tests, but they can combine hours for purposes of material participation (IRC Sec. 469(h)(5)).

This means one spouse can qualify as a real estate professional on their own and can then combine the non-real estate professional spouse’s material participation hours in rental activities to qualify jointly for material participation. 

Important point #3
Material participation is measured on an activity-by-activity basis. So if you have multiple rentals, you must meet one of the seven tests for each rental separately.

You can make grouping elections to combine all rentals into one activity for the purposes of material participation. Please discuss with your tax advisor prior to making such elections.

The IRS Audit Technique Guide
The IRS developed the Passive Activity Loss Audit Technique Guide which it provides to the field agents conducting audits. It’s meant to break down complex topics into easy-to-understand steps.

Here is that excerpt again on material participation: 

Indicators that the taxpayer did not materially participate: 

• 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. 

We bolded three of these bulleted points for emphasis. 

As you can see, the IRS will take the position that on-site management and logging hours that don’t materially impact operations are not actually material participation hours.

Takeaways

Landlords generally want their rentals to be considered “non-passive” because most rentals generate tax losses and using those tax losses to offset W-2 and business income is an excellent way to reduce one’s tax burden.

To make rentals non-passive, a taxpayer must be a real estate professional AND materially participate in the rental activity (or grouped rental activities).

Material participation hours are those impacting the day-to-day operations. There are seven tests for material participation and you must meet one of them.

Don’t mess around with material participation hours. Education, research, most travel, and investor hours will not count for material participation time.

Be very careful who you listen to on the topic of material participation. Many investors want to take the easy road and their advisors allow them to do so in order to avoid damaging a relationship. But they don’t realize that losing the eventual audit will cost them much more than the relationship.