The primary difference between active vs material participation is that active participation requires less involvement. If you participate “materially” instead of “actively,” that level of participation may affect how and when you can take a loss on your tax return, how much of a loss you can take, and the available options for tax strategy.
- Use active participation when dealing with rental properties where the owner is involved in management but does not spend extensive time personally handling daily operations. It is beneficial for landlords seeking tax relief on rental losses.
- Use material participation when engaging in a trade or business where the owner takes an active, substantial role in daily operations. It benefits business owners who want to deduct all business losses against other non-passive income.
Impact of each participation level on loss deduction
Losses from passive activities (where there is no material participation) can only offset passive income and cannot be deducted against wages or business profits. Meanwhile, if you materially participate in a business or rental activity, you can fully deduct losses against active income.
When you have active participation in a rental activity, you can deduct up to $25,000 in rental real estate losses against ordinary income, but this benefit phases out if you have AGI over $100,000. In contrast, if you materially participate, you do not have statutory limits on the amount of losses that can be used to offset active income.
Impact of each participation level on tax planning strategy
Active participation could impact your tax planning strategy by helping you ensure that your activity level meets the criteria to deduct $25,000 in losses against ordinary income. These additional losses could be useful in a year when you have large income from other sources. It’s also important to know that with active participation, the loss is limited to $25,000; this way, your strategy doesn’t anticipate losses over $25,000 that the IRS would subsequently deny.
On the other hand, material participation could impact your tax planning strategy by enabling you to identify your eligibility for losses that exceed the $25,000 limitation imposed on those who only meet the active participation standard. Being aware of the loss allowance based on material participation will help you determine the amount of income from other sources that your losses can offset.
Who do active and material participation apply to?
The active participation test mainly applies to rental real estate activities where the owner is involved in management but does not have extensive day-to-day involvement. Here are examples of businesses that would be subject to the test:
- Individual landlords who own rental properties and make key management decisions but do not spend significant time managing the property.
- Small real estate investors who own a small number of rental units, review tenant applications and lease agreements, and make major repair decisions.
- Passive real estate partnerships where an investor owns at least 10% of a rental property and participates in key decisions without managing daily operations.
On the other hand, the material participation test applies to businesses where the owner is significantly involved in operations, often meeting IRS tests for material participation. Here are some businesses subject to this test:
- Small business owners (e.g., retail stores, restaurants, service businesses) who work full-time managing operations.
- Freelancers and consultants who actively engage in projects and client interactions.
- Real estate professionals who spend over 750 hours annually in real estate activities (e.g., realtors, house flippers, property managers).
- Active investors in businesses (e.g., partners in a law firm or medical practice) who regularly make business decisions and manage employees.
- Family-run businesses where the owner and family members actively participate in daily operations.
To meet the material participation test, the owner or participant must meet one of the seven IRS material participation tests.
- You participate for at least 500 hours for the year.
- Your participation was substantially all the participation in the activity of all individuals for the tax year.
- You participate for at least 100 hours and for as much as or more than the other participants.
- You significantly participate in multiple activities for 500 hours or more, and you participate in at least one of those activities for over 100 hours.
- You participated during any five of the previous 10 tax years.
- You engaged in a personal service activity in any three of the previous six tax years.
- You participate in the business activity for at least 100 hours on a “regular, continuous, and substantial” basis.
Examples of material vs active participation
- Active participation: Michael owns and manages a wood restoration business operated as a single-member LLC. He works 1,200 hours per year, supervising employees and managing the entity’s operations. Since he meets the 500-hour rule, he is considered to materially participate. If the wood restoration business incurs an $18,000 loss, he can reduce his taxable income without the default limitations of the passive activity rules.
- Material participation: Amanda owns a rental property and oversees major decisions. She meets the 10% ownership requirement and participates in management decisions and, as such, qualifies as an active participant. If her rental property incurs a $10,000 loss for the year, she can deduct this loss from her taxable income (subject to AGI limits).
Frequently asked questions (FAQs)
Material participation on a tax return is determined by meeting one of seven IRS tests that quantify a standard of involvement in a business activity. On a tax return, material participation allows taxpayers to maximize deductions on their tax returns.
Active participation is a tax category for real estate activity that determines how much of a loss the taxpayer can take.
Hours spent working on bookkeeping, supervising employees, marketing, and providing client-facing services are all examples of time spent that count toward material participation.
Although active participation and material participation have different standards, they share some significant similarities.
- Both indicate involvement. Neither active nor material participation is passive. Both require the taxpayer to have some level of decision-making and responsibility.
- Both affect tax deductions. Each status impacts whether a taxpayer can deduct losses and how they apply against other income.
- Both require documentation. Taxpayers must be able to substantiate their participation through records, such as calendars, logs, or emails detailing involvement.
Bottom line
Knowing the difference between material vs active participation is vital for maximizing deductions and optimizing tax planning opportunities. Active participation is more attainable, mainly applicable to rental real estate, and losses are limited. Meanwhile, material participation requires significant involvement in a business or rental activity. Taxpayers should carefully document their level of involvement to determine the appropriate classification and maximize tax benefits.
