Material participation is a very specifically defined tax term in the tax code that is used to determine whether you are actively or passively participating in a business activity. The difference is significant for your taxes because passive income is treated differently on your tax return. Most significant is that if you have losses from passive activities, that negative income can’t offset your other active income (such as your job or self-employment income).
For rental properties, meeting the material participation qualifications explained in this article is only half of what is required to have your rental income be considered non-passive. This is because even if you materially participate, rental activities are still considered passive by default unless you also meet the test to qualify as a real estate professional, or if you qualify to use the short-term rental loophole.
Material Participation Qualifications
To meet the material participation test for a rental property, you need to meet any one of these tests:
- You or your spouse must do substantially all the work to manage the rental. That means you do all the management, cleaning, etc. yourself and no one else does a significant amount of work on the rental on an ongoing basis (you don’t use a cleaner, manager, etc.).
- Or if other people also help with the rental, you have to spend at least 100 hours per year on it, and that must be more time than anyone else. So if you use a cleaner that is going to spend more hours working on the property than you, one solution to that is to use multiple cleaners to keep them under your number of hours. You need to keep a log of the hours you spend on it and the time that other people spend on it also. Each individual human being’s hours are counted separately, even if several cleaners work for the same cleaning company.
- Or if anyone else spends more time on it, then you have to spend at least 500 hours per year.
- You materially participated in any 5 of the prior 10 years.
Side note: Treasury regulations section 1.469-5T defines a total of seven ways you can meet the qualification for material participation in a business, but only some of these ways are relevant to rental properties. In addition to the four above, you can qualify if the activity is a significant participation activity (SPA) or a personal service activity, but that isn’t relevant to rental properties. There is a final option to qualify if the taxpayer “participates in the activity on a regular, continuous and substantial basis.” But that option is rarely used because it is too vague and non-specific, so using that option when you don’t meet any of the other qualifications may result in scrutiny or disqualification of your participation by the IRS, so we don’t recommend relying on it.
You must meet this material participation requirement for each property that has losses that you want to deduct from your other income (unless you elect to group properties together, see more info on that later in this article).
They don’t make an exception for the first year the property is in service, so even if the first year is just a partial year, you still have to meet the same number of hours to qualify that year.
What Hours Count
Work done by either spouse of a married couple counts towards the material participation hours. But work done by your children or employees does not count.
Some of the types of work that do count towards your material participation hours include:
- Repairs and maintenance on the property
- Scheduling or managing of people who do work on the property
- Showing it to prospective tenants
- Screening tenants
- Collecting rent
- Shopping for supplies for the property
- Time coordinating with a property manager (but be aware if you have a property manager doing most of the work, you probably won’t qualify as materially participating!)
- Time spent researching a particular new property to purchase if you do actually purchase it
Some of the hours that do not count towards your material participation hours include:
- Real estate / investment education (workshops, training, podcasts, conferences)
- Work you don’t do personally (work done by your employees, kids, etc.)
- Time spent researching properties that you don’t actually purchase
- Travel time to the property (this is an area of uncertainty, see below)
- “Investor activities” such as reviewing financial reports if you aren’t involved in the day-to-day operations of the rental (see below)
A good rule of thumb is to ask yourself whether the activity is a necessary task in order for your rental property to operate. IRS publication 925 specifies that the hours don’t count if you are primarily doing the work just to accumulate material participation hours and the work isn’t something that would customarily be done by a business/rental owner.
You usually need to be self-managing your property in order to qualify. It’s technically possible to qualify if you use a property manager, but it’s much more difficult. There is an additional stipulation that if you aren’t involved in the day-to-day operations of the rental, then you can’t count hours that are merely “investor activities,” such as generating or reviewing financial reports. But that type of investor activity does count if you are also involved in the day-to-day operations of the rental.
Travel time for a trip to your rental property for business purposes may not count. This isn’t clearly defined in the tax code or regulations, but we recommend that you don’t count travel time. The IRS generally takes the position that travel time doesn’t count towards material participation hours. There are Tax Court cases (including Leyh v. Commissioner – T.C. 2015-27) where a taxpayer succeeded in having their travel time count towards their hours. But that was a summary opinion, which doesn’t establish precedence. So the IRS may likely disallow attempts to count travel time for material participation hours, and if you then go to Tax Court on the matter, there is no certainty that you will win.
General research and education hours don’t count. So time spent listening to real estate podcasts, reading articles like this one, or time spent researching new rental markets doesn’t count.
Grouping Properties Together
If you have multiple rental properties, and you aren’t able to meet the material participation tests for each property individually because you don’t spend enough time on each property, there is an election you can make to group multiple properties together so that you only have to meet the material participation hours requirement for the group as a whole.
Short-term and long-term properties can’t be grouped together. So if you put enough hours into your short-term properties (7 days or less average stay) to materially participate, unfortunately you can’t add your long-term properties to that same group. So you would need to separately put in enough hours into the long-term properties to qualify for material participation for those properties. Long-term properties are grouped under an election defined in tax code section 469(c)(7)(A) and Treas. Reg. 1.469-9(g). Short-term rentals with an average stay of 7 days or less are grouped using a different election for “non-rental” businesses under Treas. Reg. 1.469-4.
Syndicated real estate investment deals where you are a limited partner are also included in the group. This is only relevant for people who qualify for real estate professional status. But in that case, it can be used to potentially make your passive syndicated investments losses deductible.
When you make this election, you are electing to group all of your long-term rentals together on an ongoing basis for future tax years as well. New long-term rentals you buy are automatically included in the group. The tax code only allows you to revoke the election if there is a “material change” in your facts and circumstances. This can be a gray area, and it’s not always clear exactly what types of changes qualify for that exception, but possibilities include if you sold the properties, or in the even of a major life change such as marriage, divorce, retirement, or relocation.
And considering that, there is a significant drawback with grouping properties to be aware of. Normally, when you sell a property, the sale unlocks any unused passive losses related to that property. But if you made the rental grouping election, any unused passive losses can’t be unlocked until you sell all your rental properties. That may not be a problem if you don’t have unused passive losses because you were able to use the losses because you qualified for real estate professional status, for example. But it could still be a concern if you have left over unused passive losses before you had that qualification.
Logging/Tracking Hours
If the IRS asks for proof that you spend enough hours on your rental, you’ll need to be able to show documentation showing how you or your spouse spent the time that you are claiming. You should have records to show the date, the hours spent, and a description of what work you did.
You can log the hours by writing it in a document or a spreadsheet, but there are also phone and web apps that are designed to track hours. Some examples are Clockify, Toggl, and REPStracker.
If you are using the 100 hour rule that requires you spent more than time on it than anyone else, you must additionally document the hours that anyone else spent on it to be able to prove that you spent more time on it than they did. Yes, it is a bit of a hassle, and it does take some real dedication and effort to keep track of the necessary logging and documentation.
Frequently Asked Questions
If the property is owned by partners, does each have to materially participate? Each partner must meet the material participation requirement on their own (unless they’re a married couple). So each partner that wants to meet the requirement must put in enough hours to qualify as materially participating.
