Material Participation: A Game Changer for Your Business

If you’re wanting to lower taxes, then one of the BEST strategies is to invest in real estate.

Two of the more popular ways has to do with either:

• Becoming a real estate professional
• Using the short-term rental tax loophole

Real Estate Professional

The IRS states that in order to qualify for Real Estate Professional status (REPs), you must meet these conditions:

#1. Must spend the majority of your time (more than 50%) in real property businesses in which you materially participate.

#2. Must spend 750 hours or more in the real property business and rentals in which you materially participate (roughly 15 material participation hours per week).

Short Term Rental Tax Loophole

If you’re a high-income professional, time is limited. For this reason, it’s VERY difficult to become a real estate professional. Example, if you’re a full-time surgeon, finding time to spend more than 50% in a real estate business would be tough to do.

This is one of the reasons that many professionals are using the short-term rental tax loophole to lower their ACTIVE income thus pay less taxes.

Similar to becoming a real estate professional, you must also “materially participate” in the short term rental business (i.e. Airbnb).

This strategy is in the internal revenue code under Reg. Section 1.469-1T(e)(3)(ii)(A), and defines exceptions to the definition of “rental activity.” The gist of it is that if you follow the rules, then income from a rental property can be excluded from the definition of a rental activity, and thus is not automatically passive.

Here are the steps to take in order to accomplish this:

• Purchase a short-term rental.
• Materially participate in the rental business.
• Schedule a cost segregation study.
• Use accelerated depreciation the first year of purchase.
• Claim paper losses from your business/practice.
• Work with a CPA (real estate) who understands this strategy.  

If you’re an investor in a limited liability company (LLC), limited partnership, or a business partner, you’ve probably heard the term “materially participate.” Until I started investing passively in real estate syndications, I was unfamiliar with this term. 

Do you want to lower your taxes and increase your cash flow? Schedule your cost segregation study HERE.

If you want to learn more about syndications, check out this video:

If you’re unsure about exactly what material participation means, then this article has you covered.

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What Is Material Participation?

The Internal Revenue Service uses “material participation” as a classification that focuses on a taxpayer’s level of participation in their

• rental activities
• business activity
• income producing activities

Material participation occurs when a taxpayer is involved in a business on a regular, continuous, and substantial basis.

In other words, if you’re actively involved in business operations, then you’ve materially participated. 

The Difference Between Passive Investing and Material Participation 

One of the most frequently asked question I get when it comes to investing passively in syndications has to do with depreciation and taxes.

According to the passive loss rules, the key difference between material participation and passive investing is that passive real estate investors (i.e. limited partner/LP) can only deduct passive activity losses from passive activity income.

This is also known as passive activity loss limitations.

In other words, the depreciation obtained from a syndication investment can offset any of the passive income (distributions) it sends to its investors. 

This income is passive as the limited partner is NOT actively involved in the investment/property. Any passive losses that exceed the passive income can be used as a deduction in a later taxable year in which there is more passive income available to use as an offset.

(I’m NOT a CPA so check with one before implementing any information or taking legal advice from this article.)

What are Material Participation Tests?

In order to materially participate, a person must pass one of seven different tests to determine if they actively participated in a business, trade, or other income-producing activity.

If a taxpayer passes one of the seven tests, they qualify as a material participant.

Remember that material participation includes being involved in the operations of an activity on a standard, continual, and significant basis.

Those who pass these tests can deduct any losses incurred in the business from their tax return. On the other hand, if at least one of the tests aren’t met then the passive activity loss rules apply. This means that their ability is limited to deduct passive losses on tax returns.

What Are The Passive Activity Loss (PAL) Rules?

As previously discussed, losses involving passive business activities (i.e. limited partnerships) can’t be used against non passive income. This comes from the Passive Activity Loss (PAL) rules which prohibit taxpayers from doing so.

But remember any losses that are “disallowed” can still be carried forward to use and deducted from passive income or recovered when the passive business interest is sold.

How To Determine Material Participation

If you meet one or more of the following seven criteria, you materially participate in a business: 

• You participated for more than 500 hours during the tax year.
• Your activity constituted all participation substantially compared to the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity. 
• Your participation was more than 100 hours and no less than the participation of any other individual. 
• You must have a significant participation activity for more than 100 hours, and your combined activity in all significant participation activities exceeds 500 hours. 
• You materially participated in the activity (other than by meeting this fifth test) for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.  
• Personal service activity (non-income-producing) for three of the previous taxable 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 isn’t a material income-producing factor.
• You participated for more than 100 hours in a regular, continuous, and substantial basis during the year.

Why Should You Materially Participate in a Business? 

Everyone’s financial situation is different.

In the LLC or LLP that you materially participate in, you’re able to deduct the full amount of business losses on your tax return.

So if you want a way to tremendously lower your tax burden, then consider becoming a material participant.

Let’s use an example and assume that you own a 35% share in an LLC that takes a $100,000 loss in a given year. In this situation, you’re able to potentially deduct $35,000 on your tax return, thus offsetting W-2 or other nonpassive income. 

If you were a passive participant only (no active participation), then you could only deduct that $35,000 against other passive income. 

Bottom Line

If you want to save a significant amount of money when filing taxes, then consider being a material participant in a business or income-producing activity.

In order to do so, you must first pass one of the IRS material participation tests.

This is especially true if you engage in real estate activities as you’re able to use any losses incurred to offset your income from other sources.

Do you want to lower your taxes and increase your cash flow? Schedule your cost segregation study HERE.

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