Classroom participation points may boost a child’s grade in history class, but merely raising your hand won’t get you far with the IRS.  The passive activity loss rules under I.R.C. § 469 can make a real economic loss feel like a tax detention: present on the books, but not allowed as a deduction against active income. 

For CPAs and tax advisors, the issue is often not whether there was a loss or the amount, but more whether the taxpayer accrued enough participation points (i.e., materially participated in the business) to deduct the losses against ordinary income.  If not, the taxpayer is left with a gold star or participation trophy rather than the economic benefit of reducing their tax bill. 

This post provides a high-level overview of the passive activity loss rules, explains the IRS’s material participation tests, and highlights issues that CPAs, tax advisors, and real estate professionals should be aware of before the IRS says, “Recess is over!”

The Passive Activity Rules, in Plain English

In 1986, Congress enacted Section 469 to address concerns that taxpayers were sheltering active income (e.g., salary and portfolio income) by deducting losses from passive activities like rentals and leases.  Two years later, the IRS promulgated temporary regulations which contain tests and exceptions for determining whether a taxpayer’s interest in an activity is active or passive.  

There are only two types of passive activities: (1) a trade or business in which the taxpayer does not materially participate, and (2) rentals (e.g., equipment leasing and rental real estate) regardless of how much the taxpayer participates.  But a “real estate professional” may deduct rental real estate losses if they materially participate.  Thus, the material participation test applies to both businesses and to rentals of a real estate professional.

A taxpayer qualifies as a real estate professional if: (1) more than 50% of their personal services during the tax year are performed in real property businesses in which the taxpayer materially participates, and (2) the taxpayer spends more than 750 hours in real property businesses and rentals in which he materially participates. 

A taxpayer is like a student, both get some credit for participating, but passing (one of) the test(s) is key to getting a good grade on your report card (or deducting losses against active income). 

Material Participation Tests: Pass, Fail, or Facts and Circumstances

For passive activities, the temporary regulations provide seven tests and satisfying any one test can establish material participation.  Four of the tests are “pass” or “fail” math tests based on the number of hours worked.  Two tests look to the taxpayer’s activities in prior tax years.  And the last test is a catchall that reviews all the facts and circumstances.

A taxpayer is treated as materially participating in an activity for the tax year if and only if:

1. The individual participates in the activity for more than 500 hours during such year;
2. The individual’s participation in the activity for the tax year constitutes substantially all of the participation in that activity of all individuals for that tax year;
3. The individual participates in the activity for more than 100 hours during the tax year, and no other individual participates more than the taxpayer;
4. The activity is a “significant participation activity,” and the taxpayer’s aggregate participation in all significant participation activities during the tax year exceeds 500 hours;
5. The taxpayer materially participated in the activity for any 5 of the 10 immediately preceding tax years;
6. The activity is a personal service activity, and the taxpayer materially participated for any three preceding tax years; or
7. Based on all the facts and circumstances, the taxpayer participated on a regular, continuous, and substantial basis.

The last test is subject to special limits for management activity and a more-than-100-hour floor.

Seven tests to show material participation, but a taxpayer only needs to pass one.  Sounds easy, right? Perhaps, but a taxpayer still needs to produce evidence to show they satisfy one of the tests during an IRS audit or in court. 

IRS Passive Loss Audits: A Brief Study Guide

So what does the IRS look at?  First, hours: how many, when performed, and whether the taxpayer has documentary evidence to substantiate the number of hours.  Second, the type of work: is the taxpayer substantially involved in the operations of the business (i.e., hands-on), managing the day-to-day activities of the business, or merely reviewing financial statements and signing checks.  Third, business operations and non-taxpayer involvement: were managers, property managers, contractors, employees, or family members doing substantive works, was the taxpayer actually working or on stand-by.

While documentation is important, perfection is not required.  A taxpayer can establish material participation through any “reasonable means” including appointment books, calendars, and narrative summaries.  Importantly, daily time logs are not required.  But “reasonable means” does not include post-tax year ballpark estimates and exaggerated hours without supporting evidence.

Another audit magnet is grouping activities.  Although a taxpayer can file an election to group multiple activities into one to prove material participation, the IRS may regroup activities during an audit if it the grouping is not “an appropriate economic unit” and a principal purpose of grouping is avoiding the passive activity loss rules.

Regardless of the questions asked, a taxpayer (and their advisor) should have an answer supported by credible evidence.  Speculating about the number of hours worked or services performed is like guessing the answer to a test question, neither leads to a good result. 

Material Participation Checklist: Passing the Test (and Deducting Losses)

For a taxpayer claiming material participation and deducting active losses, an advisor should review:

• Time logs, calendars, appointment books, emails, text messages, and narrative summaries identifying the service performed and the number of hours;
• Documentation showing the nature of the work, separating operating activities from investor activities;
• Property management contracts, payroll records, contractor invoices, maintenance records, and tenant communications showing who did the work;
• Grouping election statements, including names, addresses, EINs, and any declarations supporting the position that the grouped activities form an appropriate economic unit;
• For real estate professionals, records proving both the 750-hour test and the more-than-50% personal services test, including W-2s or professional practice hours that may undercut the 50% test;
• For married taxpayers filing jointly, a spouse-by-spouse hour analysis, because spousal participation can count towards material participation;
• Evidence that hours claimed are for services performed, not merely for on-call hours, commute time, or after-the-fact estimates created to satisfy the 500 or 750 hour tests.

The bottom line is simple: maintain documents identifying the services performed and hours worked for each tax year.  Learning the rules, preserving and reviewing contemporaneous records, and doing the work, are all crucial when dealing with passive activities.  After all, you can’t go back to school after the IRS begins the exam.