What are the material participation tests?

What it is

The passive activity rules in IRC §469 separate income and losses into passive and nonpassive groups. A trade or business in which you do not materially participate is passive, and its losses generally offset only passive income. Material participation means being involved in the operations on a regular, continuous, and substantial basis, and the regulations turn that standard into seven tests.

The tests matter most for owners of businesses they do not run full-time, such as a franchise, a partnership interest, or a side business, and for short-term rentals and real estate professionals.

What the law says

IRC §469(h)(1) says a taxpayer materially participates only if involved in operations on a regular, continuous, and substantial basis. IRC §469(c)(2) treats rental activity as passive except as provided in §469(c)(7). Temp. Treas. Reg. §1.469-5T(a) provides that an individual materially participates if and only if the individual meets one of seven tests.

The tests are: (a)(1) more than 500 hours; (a)(2) substantially all of the participation of all individuals; (a)(3) more than 100 hours and not less than any other individual; (a)(4) significant participation activities totaling more than 500 hours; (a)(5) material participation in any 5 of the preceding 10 years; (a)(6) a personal service activity with material participation in any 3 prior years; and (a)(7) a facts-and-circumstances test requiring more than 100 hours.

Requirements and tests

When applying the tests, keep these rules in mind:

• Work counts if it is work an owner would customarily do; investor-type work such as reviewing statements does not, unless you are directly involved in day-to-day management or operations.
• Your spouse's participation counts as yours, even if the spouse has no ownership interest.
• For the (a)(2) and (a)(3) tests, the hours of every individual, including employees and property managers, are compared with yours.
• Under the (a)(7) test, time spent managing the activity does not count if anyone else is paid to manage it or if another individual spends more hours managing it.
• Limited partners generally can use only the (a)(1), (a)(5), and (a)(6) tests.
• You may prove participation by any reasonable means, but contemporaneous logs are the strongest evidence.

How it works

Define the activity first, including any grouping of activities under Treas. Reg. §1.469-4. Then add up the hours you and your spouse spent on qualifying work during the year and compare them with the tests and with other people's hours. If any test is met, the activity is nonpassive for that year: losses can offset other income, subject to basis, at-risk, and excess business loss limits, and income from the activity is not passive income.

Grouping matters. If you group two businesses as one activity, hours in either count toward the combined activity, which can help you meet a test. The grouping must be an appropriate economic unit, must be disclosed under Rev. Proc. 2010-13, and generally cannot be changed later unless the original grouping was clearly inappropriate or circumstances change materially. Rental and nonrental activities generally cannot be grouped unless one is insubstantial relative to the other or ownership is identical.

For a rental activity, passing a test is not enough by itself. The rental remains passive unless you are a real estate professional under IRC §469(c)(7) or the activity is excluded from the definition of rental activity, for example because the average customer use is seven days or less.

Risks and IRS scrutiny

Examiners test hour claims against other evidence, such as employment, travel, and the hours of managers and staff. Reconstructed logs, round-number estimates, and time that is really investor activity are common reasons claims fail. If material participation is denied, losses are suspended, and an accuracy-related penalty may apply.

Material participation is only one part of the passive-activity framework. Suspended losses remain limited until there is passive income or a qualifying complete disposition, and basis, at-risk, and excess-business-loss limits can apply before a loss reaches the return. Rental owners should also review active participation, real-estate-professional rules, short-term-rental exceptions, grouping elections, and the release of suspended losses.

Also note that material participation can cut the other way: income from an activity in which you materially participate cannot be used to absorb passive losses from other activities.

Who it is not for

These tests usually will not help passive investors who rely on a manager, owners whose involvement is limited to financial oversight, or owners of long-term rentals who do not qualify as real estate professionals. They also do not fit anyone unwilling to keep a detailed time record throughout the year.

How ebotCPA helps

We define your activities, match your real involvement to the tests, compare it with other people's hours, and set up a record-keeping system so your return position can be supported.

Book a $497 Case Analysis to have Ebot Mbi, CPA, EA review your facts before you act.

Primary sources

1. Temp. Treas. Reg. §1.469-5T(a). Material participation tests.

   “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;”

   Lists the seven tests for material participation.

2. Temp. Treas. Reg. §1.469-5T(f)(2)(ii)(A). Investor-type work.

   “Work done by an individual in the individual's capacity as an investor in an activity shall not be treated as participation in the activity for purposes of this section unless the individual is directly involved in the day-to-day management or operations of the activity.”

   Excludes investor work unless the individual is directly involved in day-to-day management or operations.

3. 26 U.S.C. §469(h)(1) and (c)(2). Material participation; rental activity passive.

   “Except as provided in paragraph (7), the term 'passive activity' includes any rental activity.”

   Defines material participation and treats rental activity as passive except under §469(c)(7).

4. Passive Activity Loss Audit Technique Guide. IRS audit techniques for passive activity losses.

   Lists the IRS audit technique guides, including the guide examiners use for passive activity losses and real estate professional claims.

5. IRM 20.1.5. Return Related Penalties.

   Sets out how examiners assert the IRC §6662 accuracy-related penalty when a position is not supported.

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