How to navigate the IRS Passive Loss Labyrinth, continued from Part II

Real Estate Professionals and Material Participation. This is the third of IV parts.

By Gary Krupa, CPA

Updated:

September 7, 2021
September 8, 2021

The IRS Passive Loss Labyrinth

Material participation tests according to the IRS regulations

There are seven quantitative tests. You need to pass only one of these tests in order to qualify for a tax year. Here they are:

Test no. I. You need to participate in the activity for more than 500 hours.

Test no. II. You need to participate for all or nearly all of the time spent on such an activity for the year.

Test no. III. You need to participate for more than 100 hours during the tax year, and for no less than any other individual for the year.

Test no. IV. You need to spend more than 500 hours in all significant participation activities during the tax year.*

Test no. V. You materially participated in the activity for five of the preceding 10 tax years.

Test no. VI. The activity has to be a personal service activity. It’s also one you must have materially participated in for any three tax years preceding the tax year.**

OR

Test no. VII. You must participate in the activity on a regular, continuous, and substantial basis during the year, based on all of the facts and circumstances.

You’d determine material participation on an annual basis.

Other considerations for determining your material participation

Don’t count the hours you spend as an employee unless you own at least 5% of your employer.

A District Court interpreted the RE Professional rules more flexibly than the IRS did. I.E. It ruled that an attorney may count his or her legal services for a Real Estate firm as real estate services.

The ruling applies to services in other fields beside real estate as well. It may include bookkeeping or secretarial work you do for a real estate office. As a result, you can count your time spent performing non-real estate services.

You must manage or assist in the managing of your real property trade or business. If all you do is invest in the business or manage its finances, you can’t count your hours spent as material participation.

A limited partner in a real property activity may prove material participation by satisfying tests no. 1, 5 and 6 above.

If you’re married and own a real estate activity, you must count your spouse’s hours of service in the activity. That’ll help you establish material participation, yet it won’t help you qualify as a Real Estate Professional.

See Step 3 in Part II under “Next, determine whether or not you qualify”.

How to substantiate your material participation

You can do this for an activity by any reasonable means. For example, you can maintain time reports or logs, but it’s not required. All you need to do is make entries in your appointment book, on your calendar, or in a work diary. That way you can estimate the number of hours you spend that way.

Yet the courts have held that the IRS doesn’t have to accept a “ballpark estimate”. That’s why your records should be “contemporaneous”, or maintained around the same time as your activity or shortly thereafter.

Next, in Part IV: How to avoid having to pay the Net Investment Income Tax (NIIT)

For more information on Material Participation

Re: Material Participation / Remote location hours, read this The Tax Adviser article: MPRLH

If you’re ambitious about this topic, I suggest reading Temporary regulation Section 1.469-5T(a)(5)

*Meaning a trade or business you’re involved in for more than 100 hours during a tax year. It doesn’t include a rental activity unless you provide services. In general, in a trade or business, you sell goods, perform services or do both. At the same time, you don’t materially participate in it under tests 1 to 3 and 5 to 7 listed here.

** In other words, one in which you perform personal services. It can be in a professional field such as health, law, engineering, architecture, accounting, actuarial science, performing arts, and consulting. Or it can be in a trade or business in which capital is not a material income-producing factor.