Material participation is a term used in U.S. tax law to describe the level of involvement a taxpayer has in a business or income-generating activity. The concept is used primarily to determine whether a taxpayer can deduct losses from passive activities.
The Internal Revenue Service (IRS) considers a taxpayer as materially participating in a business if they are involved in its operations on a regular, continuous, and substantial basis. The IRS has provided seven tests in the Internal Revenue Code Section 469, and meeting any one of these tests during the taxable year qualifies the taxpayer as materially participating.
These tests include the following:
- The individual participates in the activity for more than 500 hours during the year.
- The individual’s participation in the activity for the tax year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.
- The individual participates in the activity for more than 100 hours during the tax year, and the individual’s participation in the activity for the tax year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year.
- The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours.
- The individual materially participated in the activity for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year.
- The activity is a personal service activity, and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year.
- Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during such year.
This distinction is important because losses from passive activities—those in which the taxpayer does not materially participate—can only be used to offset income from other passive activities. But if the taxpayer materially participates in the activity, the losses can be used to offset other non-passive income, such as wages, interest, and dividends.
Example of Material Participation
Let’s consider a real estate investment scenario.
John owns a full-time job as a software developer, but he also owns a rental property as a side investment. The property generates a loss of $10,000 for the year due to expenses like mortgage interest, property taxes, and maintenance costs exceeding rental income.
- Scenario A – Non-Material Participation: John hires a property management company to manage the property. He only spends about 20 hours during the entire year dealing with property-related matters, such as reviewing reports from the management company and making major decisions. In this scenario, John is not considered to be materially participating in the rental activity according to the IRS rules. This is considered a passive activity, and the $10,000 loss is a passive loss. If John has no other passive income (e.g., from other rental properties or partnerships), he cannot currently deduct the $10,000 loss from his wages as a software developer or any other non-passive income. Instead, the loss will be carried forward to future tax years and can offset passive income in those years.
- Scenario B – Material Participation: Let’s say instead of hiring a property management company, John decides to manage the property himself. He spends over 100 hours during the year dealing with tenant issues, collecting rent, maintaining the property, etc., and no other individual spends more time than John in the property-related activities. In this case, John may meet one of the IRS tests for material participation (test number 3, for example), depending on the exact circumstances. If he’s considered a material participant, the $10,000 loss is not classified as a passive loss. He can deduct the loss from his non-passive income (like his wages from the software developer job), reducing his taxable income for the year.
This is a simplified example and actual tax situations can be more complex. It’s always a good idea to consult with a tax professional to understand the implications fully.