How to Qualify as a Materially Participating Real Estate Professional

The tax code designates certain individuals as “materially participating real estate professionals,” which allows them to overcome the rule that treats rental activities as passive. Normally, passive activity losses can only offset passive income. Achieving this status reclassifies rental real-estate losses as non-passive, allowing them to be deducted against other income sources like wages or business profits for potential tax savings.

Qualification involves meeting two sets of Internal Revenue Service (IRS) tests: one to be recognized as a real estate professional and another to prove material participation in rental activities. The burden of proof is on the taxpayer to substantiate their eligibility through detailed records. Failure to meet these requirements can lead to the disallowance of losses during an IRS examination.

Qualifying as a Real Estate Professional

To be considered a real estate professional, a taxpayer must pass two quantitative tests outlined in the tax code. These tests are designed to ensure the individual dedicates a significant amount of time to real estate activities. Both hurdles must be cleared annually for the taxpayer to earn the designation for that tax year.

The first is the “more than one-half personal services” test, which requires that over 50% of the total personal services performed during the year are in real property trades or businesses. The time spent on real estate work must exceed the time spent in all other professional capacities combined. For example, someone working 1,000 hours in a non-real estate job must work at least 1,001 hours in real estate to qualify.

The second requirement is the “750-hour” test, which mandates that the taxpayer perform at least 750 hours of service in real property trades or businesses. The IRS defines “real property trades or businesses” to include activities such as development, construction, acquisition, conversion, rental, management, leasing, or brokerage.

A spouse’s hours can be counted toward meeting the material participation tests for a rental activity, but they cannot be used to help the other spouse meet the 750-hour or 50% tests. Additionally, personal services performed as an employee in a real estate business do not count toward these tests unless the individual owns more than 5% of the employer.

Meeting the Material Participation Standard

Qualifying as a real estate professional does not automatically allow for the deduction of rental losses. After meeting the 750-hour and 50% tests, the taxpayer must also demonstrate material participation in their rental real estate activities. The IRS provides seven tests for this, and a taxpayer only needs to satisfy one each year for their rental activities to be considered non-passive.

The 500-hour test is met if the individual participates in the activity for more than 500 hours during the tax year. For many who have already cleared the 750-hour professional status hurdle, this is a common target for their rental properties. Hours spent on various management tasks can be aggregated to meet this threshold.

The “substantially all” participation test is met if the taxpayer’s participation for the year constituted nearly all of the participation by any individual, including non-owners. This test is useful for owners who handle every aspect of the rental themselves without help from property managers or contractors.

The 100-hour test requires two components: the taxpayer must participate for more than 100 hours, and that participation must be at least as much as any other single individual. This test can be difficult to meet if a property manager or contractor also dedicates significant time to the property.

Under the significant participation activity (SPA) test, an activity is an SPA if the individual participates for more than 100 hours. To meet the standard, the taxpayer’s total participation in all of their SPAs combined must exceed 500 hours, allowing aggregation of time from multiple interests.

Two tests look back at prior years. The five-out-of-ten-year test is met if the taxpayer materially participated in the activity for any five of the ten preceding tax years. The three-year personal service activity test applies if the activity is a personal service activity and the taxpayer materially participated for any three prior years.

The “facts and circumstances” test requires the taxpayer to show regular, continuous, and substantial participation during the year for more than 100 hours. This test cannot be used if any other individual received compensation for managing the activity or if another individual spent more hours than the taxpayer managing the property.

The Grouping Election for Rental Activities

A taxpayer can choose to group multiple rental properties into a single activity to help meet the material participation standard. The IRS allows a formal election to treat all interests in rental real estate as one activity for tax purposes. This permits the aggregation of hours spent across all properties, making it easier to clear thresholds like the 500-hour test.

Without this election, a taxpayer must establish material participation for each rental property separately. By grouping them, the hours spent on all properties—such as screening tenants, overseeing repairs, and collecting rent—can be combined into a single total.

To make the election, the taxpayer must file a statement with their original income tax return for the year it becomes effective. The statement must declare that the taxpayer is a qualifying real estate professional and is electing to aggregate all rental real estate interests.

The grouping election is binding for all future tax years and cannot be revoked without a material change in the taxpayer’s circumstances or with formal consent from the IRS. Because the election is binding, taxpayers should consider their long-term strategy before making it.

While beneficial for participation tests, the grouping election has a drawback concerning suspended passive losses. When properties are treated as a single activity, the sale of one property is not a complete disposition. As a result, any suspended passive losses from that property are not released upon its sale. These losses remain suspended and can only be used to offset future income from the remaining properties within the group until the entire interest in the grouped activity is sold.

Substantiating Your Status

The responsibility for proving eligibility for real estate professional status rests with the taxpayer. The IRS can disallow loss deductions if it is not satisfied with the evidence presented during an audit, so maintaining detailed records is required to defend the tax position.

The best way to substantiate hours is with a detailed log or calendar maintained throughout the year. This log should document the date, hours spent, and a precise description of the services performed. For example, instead of “property management,” a better entry is “2 hours spent screening three tenant applications, including credit and background checks.”

Qualifying activities involve hands-on management and operational duties. Time spent arranging for and supervising repairs, purchasing supplies, and performing inspections also counts. Other qualifying activities include:

• Advertising the property
• Showing units to prospective tenants
• Negotiating leases
• Collecting rent
• Responding to tenant requests

Conversely, activities considered investor-related do not count as participation, as the focus is on active involvement rather than monitoring an investment. This includes time spent reviewing financial statements, preparing financial projections, or traveling to and from the property unless specific management tasks are performed during the trip.