Tax Laws can be confusing.  Let us help.

Here is some information which could be helpful if you own rental property or a small business.

 

A. Active Participation

If you own rental real estate, this is generally considered a “passive activity”.  That is not a problem, unless the rental generates a loss because passive losses are normally not deductible unless you have passive income.  But, as with all things from the IRS, there is an exception for “lower” income taxpayers.  (That is AGI under $100k) You may be able to deduct up to $25,000 of passive rental real estate losses if you “actively participate”.

IRS Pub 925: Active participation is not the same as material participation (defined below). Active participation is a less stringent standard than material participation. For example, you may be treated as actively participating if you make management decisions in a significant and bona fide sense. Management decisions that count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

It is very important that you have documentation for these “management decisions”.  Further, Active Participation is determined annually.  So, you might participate actively one year, but not the next.

B. Material Participation

For most other businesses (partnerships, sole proprietorships, s-corporations), there is a different set of standards for determining whether or not your participation was “passive”.  Material Participation requires quite a bit more involvement in the business operations.

Like active participation, material participation has an annual determination and calls for written documentation such as logs, calendars, notes, schedules, etc.

A trade or business activity is not a passive activity if you materially participated in the activity.

IRS Pub 925:

Material participation tests.    You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests.

  1. You participated in the activity for more than 500 hours.
  2. Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
  3. You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
  4. The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
  5. You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
  6. The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it 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.
  7. Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.

You did not materially participate in the activity under test (7) if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity does not count in determining whether you materially participated under this test if:

  • Any person other than you received compensation for managing the activity, or
  • Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
Participation.   In general, any work you do in connection with an activity in which you own an interest is treated as participation in the activity.

Participation as an investor.   You do not treat the work you do in your capacity as an investor in an activity as participation unless you are directly involved in the day-to-day management or operations of the activity. Work you do as an investor includes:

  • 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 your own use, and
  • Monitoring the finances or operations of the activity in a nonmanagerial capacity.
Spouse’s participation.   Your participation in an activity includes your spouse’s participation. This applies even if your spouse did not own any interest in the activity and you and your spouse do not file a joint return for the year.