A passive activity is defined as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate” according to Code Section 469(c)(1). Also included in the definition are rental activities, without regard to the extent of taxpayer participation. This basically excludes trade or business activities in which a taxpayer does materially participate are not passive activities. In terms of real estate activities, these are generally considered to be passive no matter the amount of involvement by the taxpayer.
Changes in Material Participation
“Material participation” requires a taxpayer to be involved in the operations of the activity on a regular, continuous, and substantial basis. In some cases, a taxpayer may own a profitable business that could be turned into a passive activity in which the taxpayer would be able to offset passive losses.
The change from an active business to a passive activity could possibly be achieved by lowering a taxpayer’s level of participation in the ongoing business operations. Material participation was basically designed to include all passive business owners by at the same time exclude certain business owners from being subject to the passive loss rules.
Material vs Passive
A business in which an individual materially participates is not a passive activity. Therefore, if the business experiences a loss, the loss will be deductible against all other types of income (passive, active, and portfolio) without regard to the passive loss restrictions.
Material Participation Tests
An individual will be treated as materially participating in an activity for the tax year if any of the following tests apply:
1. The individual participates in the activity for more than 500 hours during the tax year.
2. The individual participation in the activity constitutes substantially all of the participation in such activity of all individuals for the tax year.
3. The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation for the tax year is not less than the participation in the activity of any other individual for the tax year.
4. The activity is a significant participation activity for the tax year, and the individual’s aggregate participation in all significant participation activities during the same year exceeds 500 hours.
5. The individual materially participated in the activity for any five tax years, whether or not consecutive, during the 10 tax years that immediately preceded the tax year.
6. The activity is a personal services activity and the individual materially participated in the activity for any three tax years, whether or not consecutive, preceding the tax year.
7. Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.
It is important to consider all these tests when filing your tax return for the tax year. If any of these apply to your situation, you will be considered by the IRS to have materially participated in the activity in question.