Real Estate Material and Active Participation Rules and Passive Activities
Passive activity losses are offset against passive activity gains only, with a special loss allowance for rental real estate. Material participation avoids passive activity rules. By planning, you can avoid having the IRS deem your business as a passive activity.
This article will cover each of the seven ways that qualify as material participation. A brief discussion on partners, LLC members, and S corporations will follow. The article will end with grouping activities.
The IRS is applying added emphasis on passive activities to raise revenues. Following the rules to the letter ensure you keep your favored tax status. Accurate records of material participation offers significant tax advantages that are preserved if challenged. The rules are complex because there are so many opportunities to qualify for material participation.
Material Participation Defined
Most individuals can avoid passive activity rules by satisfying one of the following seven criteria:
- Individual spends over 500 hours in the activity.
- Individual is the only one participating in the activity. Minor services by others do not count.
- Individual spends over 100 hours and no one else spends more time than 100 hours.
- Activity qualifies as a significant participation activity (over 100 hours) and all significant participation activities aggregated exceed 500 hours.
- Individual meets material participation in any 5 of the last 10 years.
- Activity is a personal service activity, such as: law, accounting, health, performing art, or consulting, and individual had material participation in any of three prior years.
- Facts and circumstances determine the individual participated on a regular, continuous, and substantial basis. Participation must exceed 100 hours.
Partners, LLC Members, and S corporation Shareholders
General partners must meet one of the seven criteria above to meet material participation rules. Limited partners must meet 1, 5, or 6 above to be considered materially participating.
General partners that are also limited partners treat both interests as general partner interests.
LLC member limited interests are not defined in the Tax Code. The Tax Court has ruled multiple times that LLC member are not automatically limited partners. LLC members need to satisfy one of the seven criteria above.
Individuals can meet material participation rules by grouping multiple activities into one activity. The facts and circumstances should form an appropriate economic unit.
Rules to determine activity level:
- Material participation,
- For the $25,000 rental loss allowance, 10% ownership and active participation tests,
- Suspended losses deduction when activity is disposed of in a taxable transaction.
Grouping is an appropriate economic unit if entities are:
- Similar types of businesses,
- Have common control,
- Common ownership,
- Geographically local, and
- Activities are interdependent.
Grouping activity limitations:
- Rental activities cannot be grouped, with minor exceptions.
- Rental and personal property cannot be grouped.
- Limited partnerships cannot be combined with other activities.
- Groupings cannot be changed in future years unless there is a material change in the facts and circumstances.
- You cannot group for the sole purpose of circumventing passive activity rules. In other words, the group must reflect an appropriate economic unit.
- The Real Estate Professional and the IRS
Real estate professional rules can reduce taxes significantly. The rules are complex, but worth the effort. Losses over $25,000 are allowed the real estate professional.
- Passive Activity Rules
Passive activity rules can work to your advantage if you know how. Passive activity losses are limited with notable exceptions.
Material participation rules are complex, but offer significant tax advantages. Feel free to bookmark or link this article for future reference. You can share ideas in the comments sections below.