Material Participation
Understanding IRS Publication 925
IRS Publication 925, Passive Activity and At-Risk Rules, explains when losses from rental and business activities may—or may not—be used to offset other income, such as W-2 wages, business income, or investment income.
The purpose of material participation is to determine whether an activity is treated as passive or non-passive for tax purposes. A trade or business activity is generally considered non-passive if the taxpayer materially participates in the activity.
- Passive losses are typically limited and may only offset passive income.
- Non-passive (active) losses may be eligible to offset W-2 income, business income, and other active income, depending on the taxpayer’s individual facts and circumstances.
The IRS provides seven material participation tests, and satisfying any one of these tests may qualify an activity as materially participated.
Tax Strategies
Short-Term Rentals (STRs): A Unique Advantage
Certain short-term rental activities—generally those with average guest stays of 30 days or less, and in some cases where significant personal services are provided—may be treated as a trade or business rather than a rental activity under Treasury Regulation §1.469-1T(e)(3)(ii).
When a short-term rental does not meet the definition of a rental activity, material participation becomes the key factor in determining whether the activity is treated as passive or non-passive for tax purposes. This makes short-term rentals one of the most powerful strategies for high-income professionals who cannot qualify for Real Estate Professional Status (REPS).
Real Estate Professional Status (REPS)
Real Estate Professional Status (REPS) is a special IRS designation that allows qualifying taxpayers to treat long-term rental losses as non-passive. To qualify, a taxpayer generally must:
- Spend more than 750 hours per year in real property trades or businesses
- Spend more time in real estate than in all other occupations combined
- Materially participate in the rental activities (often through grouping elections)
REPS can be extremely powerful—but it is also heavily scrutinized by the IRS and must be properly documented.
Active Participation
Active participation should not be confused with material participation. It is a lower standard that focuses on whether the owner is meaningfully involved in key management decisions, rather than the amount of time spent.
An owner may be considered to actively participate when they exercise real, good-faith authority over the operation of the rental activity—such as approving tenants or guests, setting rental terms, authorizing repairs or expenditures, and making other substantive management decisions. Key characteristics include:
- No specific hour requirement. Unlike material participation, active participation does not require meeting a minimum number of hours.
- Minimum ownership threshold. The individual must own at least a 10% interest in the activity.
- Decision-making involvement. Active participation generally involves being involved in major decisions (for example, approving tenants, rental terms, or repairs), even if a property management company handles day-to-day tasks.
- Limited loss allowance. Active participation may allow up to $25,000 of passive losses from rental real estate to offset non-passive income, subject to an Adjusted Gross Income (AGI) phase-out that begins at $100,000 and is fully phased out at $150,000.
- Applies primarily to rental real estate. This standard is most commonly relevant for rental real estate owners who do not qualify as real estate professionals.
Documentation Matters
Regardless of strategy, documentation is critical. This includes:
- Contemporaneous time logs
- Clear role descriptions
- Evidence of decision-making authority
- Proper entity structuring
- Coordination with your CPA and tax advisor
Poor documentation is one of the most common reasons investors lose these benefits during an audit.
