Material Participation vs. Active Participation
Understand how your level of involvement in an activity dictates its tax treatment and your ability to deduct losses under IRS passive activity rules.
The Internal Revenue Service (IRS) uses Passive Activity Loss (PAL) rules to govern how taxpayers can use losses from certain investments. These rules prevent individuals from deducting losses from a passive activity against other income, such as wages from a job. Whether an activity is passive or non-passive depends on the taxpayer’s level of involvement. The IRS measures this involvement using two different standards: material participation and active participation, which determine if losses can be deducted against other income sources.
Understanding Material Participation
Material participation is the standard the IRS uses to determine if a taxpayer is involved in a trade or business activity enough for it to be considered non-passive. For this standard to be met, the taxpayer’s involvement must be regular, continuous, and substantial. A taxpayer must meet only one of the following seven tests for the activity to be classified as non-passive for the tax year.
- Participation in the activity for more than 500 hours during the year.
- The taxpayer’s participation was substantially all the participation in the activity for the tax year, including that of all other individuals.
- Participation for more than 100 hours during the year, and that participation is not less than the participation of any other individual.
- The activity is a “significant participation activity” for the year, and the taxpayer’s aggregate participation in all such activities exceeds 500 hours. A significant participation activity is one where an individual participates for more than 100 hours.
- Material participation in the activity for any five of the ten preceding tax years.
- The activity is a personal service activity, and the taxpayer materially participated for any three preceding tax years.
- Based on all facts and circumstances, the taxpayer participated on a regular, continuous, and substantial basis during the year, which requires more than 100 hours of participation and cannot be used if another individual was compensated for managing the activity.
Understanding Active Participation
Active participation is a less demanding standard of involvement that applies exclusively to rental real estate activities. Unlike material participation, it does not require involvement to be regular, continuous, and substantial. Instead, the active participation standard is met if the taxpayer participates in making significant management decisions, such as approving new tenants, deciding on rental terms, and authorizing repair expenditures.
To qualify for active participation, a taxpayer and their spouse must own at least 10% of the rental real estate activity. They must also have genuine involvement in management. While a taxpayer can hire a property manager for daily operations, they must retain and exercise final decision-making authority on important matters.
The tax benefit of meeting the active participation standard is the ability to deduct up to $25,000 in rental real estate losses against non-passive income. This deduction is subject to income limitations, as it begins to phase out for taxpayers with a Modified Adjusted Gross Income (MAGI) over $100,000. The allowance is completely eliminated for those with a MAGI of $150,000 or more.
Key Distinctions and Tax Outcomes
The primary distinctions between the two standards relate to their applicability and the required level of involvement. Material participation can apply to any trade or business, while active participation was created specifically for rental real estate activities. Consequently, material participation sets a high bar, demanding involvement proven by meeting one of the seven specific tests. Active participation is less stringent, focusing on management-level decision-making rather than day-to-day operations.
These differing standards lead to distinct tax outcomes for losses. Meeting a material participation test reclassifies the activity as non-passive, meaning any losses are generally fully deductible against other non-passive income without a specific dollar limit. Active participation does not change the rental activity’s passive classification. Instead, it provides a special allowance, permitting the taxpayer to deduct up to $25,000 of these passive losses against non-passive income, subject to the MAGI phase-out.
The Real Estate Professional Exception
A separate classification exists for individuals heavily involved in property trades: the real estate professional. This status allows a qualifying individual to treat their rental real estate activities as non-passive if they also materially participate. This outcome is more advantageous than the $25,000 loss allowance, as it permits the full deduction of rental losses without an income-based phase-out.
To qualify as a real estate professional, a taxpayer must satisfy two quantitative tests. First, more than half of the personal services they perform in all trades or businesses during the year must be in real property trades or businesses. Second, the taxpayer must spend more than 750 hours of service during the tax year in those same real property trades or businesses.
Meeting these two tests is not sufficient to make rental losses automatically deductible. After qualifying, the taxpayer must also demonstrate material participation in their rental activities. This requires satisfying one of the seven material participation tests for their rental properties to treat the venture as a non-passive activity.