Material Participation

A trade or business is a passive activity if the taxpayer does not materially participate in the activity. This makes the definition of material participation essential for taxpayers trying to deduct losses generated by their trade or business and avoid having their losses limited by the passive loss rules.

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At a high level, material participation is achieved if you participate in an activity on a regular, continuous, and substantial basis during the year.

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How to Prove “Material Participation”

In order to achieve material participation in an activity, you must meet at least one of the following seven tests:

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1. You participated in the activity for more than 500 hours during the tax year.
2. Your participation was substantially all of the participation in the activity of all individuals for the tax year.
3. You participated in the activity for more than 100 hours during the tax year and participated in the activity at least as much as any other individual for the tax year.
4. The activity is a significant participation activity and your participation in all significant participation activities exceeds 500 hours.
5. You materially participated in the activity for any five of the preceding ten tax years.
6. The activity is a personal service activity and you materially participated for any three (whether or not consecutive) preceding tax years.
7. You participated in the activity for more than 100 hours during the tax year and you satisfy a facts and circumstances test proving that the you participated on a “regular, continuous, and substantial” basis. Your participation in managing the activity does not count in determining whether you materially participated under this test if
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   1. Any person other than yourself received compensation for managing the activity, or
   2. Any individual spent more hours during the tax year managing the activity than you did (regardless of whether they were compensated for the management services).

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If you are married, a minority owner or LP investor in an activity, you’ll want to consider the following details:

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• Married Individuals: Any participation in activity by you or your spouse will qualify as participation for these tests, regardless of filing status and/or ownership interest in the activity.
• Employees and minority owners: You must directly or indirectly own at least 5% stake in an activity in order for your time to qualify as participation for these tests.
• Limited Partners (LPs): Material participation is only available to LPs meeting tests #1, #5 or #6. Keep this in mind if you plan to group LP interest in real estate syndicates to claim losses.

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Participation Guidelines

Any "participation" is counted unless it’s primarily performed to avoid the passive loss rules.

Proof of Participation

Your participation in an activity may be established by any reasonable means.

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Reasonable means usually involves identifying services performed and the approximate number of hours spent performing those services over a period of time. This can involve:

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• Calendars
• Work product and notes
• Appointment confirmations, or
• Narrative summaries

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Contemporaneous daily time reports, logs, or similar documents are not required if the extent of your participation may be established by other reasonable means.

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☝️ Although the regulations permit some flexibility, they do not allow a post event "ballpark guesstimate" of time committed to participation in a rental activity or your own unverified, undocumented testimony.

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Investor Participation Limitations

Investors cannot "participate" unless they are directly involved in the day-to-day management or operations of the investments. Work performed as an investor includes:

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• Studying and reviewing financial statements or reports on operations of the activity
• Preparing or compiling summaries or analyses of the finances or operations of the activity for the taxpayer's own personal use
• Monitoring the finances or operations of the activity in a non-managerial capacity.

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Relevant Definitions

For the purpose of this test, individuals include participation of individuals who did not own any interest in the activity

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A significant participation activity is one where you participate more than 100 hours during the tax year but do not materially participate under any of the other material participation tests.

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A personal service activity involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.

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Reference(s)

469(h) Material Participation Defined