Material participation in a passive activity (like owning rental property) results in non-passive treatment of the income.
Most of us know that rental owners can deduct up to $25k in losses, but this tax benefit is phased out for taxpayers with AGIs higher than $150k. Their passive losses must be carried to forward until they can be offset with future passive (rental) income.
The only other way to deduct rental losses (passive income) from non-passive income is to materially participate in the activity, and the major benefit is that your losses can be unlimited. Many people become “real estate professionals,” so they can easily meet the requirements for material participation.
If you or your spouse’s answer to any of these tests for determining material participation is yes, you can treat your rental income as non-passive and claim unlimited losses:
1. Do you work more than 500 hours a year in the business?
2. Do you do most of the work? If your participation is the only activity in the business, you materially participate…(ie sole proprietor with no employees)
3. Do you work more than l00 hours, and no one works more? If you put in l75 hours a year and an employee works 190 hours a year, you do not meet the material participation test.
4. Do you have several passive activities in which you participate between 100-500 hours each, and the total time is more than 500 hours? The following activities should not be included in the above test: rental activities, activities involving portfolio or investment income, and activities in which the taxpayer does most of the work.
5. Did you materially participate in the activity for any 5 out of l0 preceding years (ie taxpayer who retired and children now run business, but taxpayer stills owns part of partnership)
6. Did you materially participate in a personal service activity for any 3 prior years? Personal service activity includes fields of health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.
7. Do the facts and circumstances indicate that you are a material participant? This test does not apply if:
a. you worked less than 100 hours a year
b. any person, other than you, received compensation for managing the activity
c. any person spent more hours than you managing the activity
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