What Are Material Participation Tests?
Material participation tests are a set of Internal Revenue Services (IRS) criteria that evaluate whether a taxpayer has materially participated in a trade, business, rental, or other income-producing activity. A taxpayer materially participates if they pass one of the seven material participation tests. However, passive activity rules limit the deductibility of losses when taxpayer participation fails to meet at least one of the seven material participation tests.
Key Takeaways
- Material participation tests help determine whether a taxpayer has materially participated in business, rental, or other income-producing activity.
- A material participant can deduct the full amount of losses on their tax returns.
- Only one requirement of the seven material participation tests needs to be met to qualify.
- Passive activity rules limit the deductibility of any passive loss.
Understanding Material Participation Tests
Material participation in an income-producing activity is, generally speaking, an activity that is regular, continuous, and substantial. Income-producing actions, in which the taxpayer materially participates, are active income or loss. An active loss is deductible but subject to at-risk rules or other limitations imposed by the Internal Revenue Code (IRC).
Passive activity rules apply to participation that fails to meet one of the material participation tests. A passive participation in an income-producing venture is participation that is not regular, continuous, and substantial. Income-producing actions, in which the taxpayer passively participates, are passive income and loss. Passive activity rules limit the deductibility of any passive loss.
Material participation may or may not be worse than passive participation in any given situation. It's a good idea to enlist the help of a financial advisor in making that decision.
Types of Material Participation Tests
For any tax year, a taxpayer or their spouse qualifies as materially participating in a venture if they satisfy any one of the seven material participation tests.
- Test one: You participated for more than 500 hours.
- Test two: Your activity substantially constituted all participation.
- Test three: You participated for more than 100 hours and no less than any other individual.
- Test four: The activity is a significant participation activity, and you participated in it along with all significant participation activities, for more than 500 hours. A significant participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
- Test five: You participated during any five of the preceding 10 taxable years.
- Test six: The activity is a personal service activity and you participated for any three prior taxable years. Personal service activities are activities in which capital is not a material income-producing factor, such as health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting.
- Test seven: You participated for more than 100 hours and (based on all the facts and circ*mstances) on a regular, continuous, and substantial basis.
Limits to Material Participation Tests
Not all time spent in certain activities will count toward the 100-hour or 500-hour thresholds of tests one, three, four, or seven.
Time spent as an investor will not count unless you can show direct involvement in the day-to-day management of the activity. Work not customarily done by an owner is not counted towards material participation hours, nor is time spent commuting. Work undertaken for the primary purpose of avoiding the disallowance of losses under the passive loss rule is not material participation. And finally, participation in a purely managerial activity where other managers receive no compensation cannot be counted.
Real estate rental activity is generally considered passive activity, even if you materially participate, unless you're a qualified real estate professional.
The participation of limited partners in enterprises owned by them is passive participation unless they pass material participation tests one, five, or six. When a taxpayer participates in two enterprises operated through the same pass-through entity, at least one of the seven tests for each venture must be met for them to be considered to have materially participated in both activities.
Special Considerations for Material Participation Tests
Taxpayers with an ownership interest in a venture receive participation credit for work done for it. They establish their participation by identifying the hours spent and the nature of the work done. Taxpayers base participation on records they maintain, such as appointment books, calendars, narrative summaries, or any other reasonable means.
How Does the IRS See Active vs. Passive Participation in Generating Income?
So-called material participation in an activity that generates income is identified as active if it is determined to be regular, continuous, and substantial. This kind of participation must pass the material participation tests devised by theIRS. Passive participation that generates income is characterized as the opposite of active—it's activity that is not regular,continuous, or substantial.
How Do You Verify Material Participation?
Taxpayers need to keep records of the number of hours of material participation in an activity, and be able to provide written evidence if need be. Tasks an investor might typically undertake, like reviewing stock charts, would not meet the participation burden, unless that taxpayer was substantially involved in the management of a particular activity.
How Does Material Participation Impact Taxes?
A taxpayer who is materially participating in an activity is allowed to deduct the total amount of losses on their taxes.Under passive activity rules, a taxpayer who is passively participating in an income-generating activity is limited in thedeductibility of losses.
The Bottom Line
Whether your participation in a particular income-generating activity is active or passive can affect your tax liabilities. To help you determine which it is, the IRS has developed seven tests you can use to evaluate your participation. If your activity counts as material participation, you'll typically be able to deduct the total amount of losses; your deductions are limited in the case of passive activity.
