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If you want to learn how to lower your taxes and in some cases, pay ZERO Federal income taxes like we did for seven years in a row, then you’re going to need to learn about material participation.
If you’re not familiar with these tax benefits, then you’re going to want to learn about real estate professional status or the short-term rental tax loophole.
So what is material participation? And for more advanced investors, what Whether you’re a new investor or an experienced one, one area where you’re probably not feeling so confident about is, what counts as material participation hours?
But before we dive into the activities that count as material participation, let’s go back and cover some of the basics.
What is material participation?
Material participation is a set of criteria or tests used by the IRS to determine if a business activity is active or passive.
There are seven tests but the following three are the ones that are used by most real estate investors:
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who didn’t own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who didn’t own any interest in the activity) for the year.
If you meet one of the above tests, then your real estate activity is considered active. For short-term rentals or vacation rentals, if you meet one of the above tests, then you can use the losses from your vacation rental to shelter your W2 or 1099 income. Sheltering your income with long-term rentals requires both material participation and an additional standard called real estate professional status.
What activities count as material participation?
The real puzzle is figuring out which activities the IRS deems as material participation, especially for long-term rentals. The IRS code Sec. 469(c)(7) provides a broad brushstroke, listing broad categories.
Here’s what they provide in Sec. 469(c)(7) of the IRS code:
Any of the following activities would qualify as material participation: “real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing, or brokerage trade or business.”
Let’s dive into each of these in order. There is a more detailed list of activities that count as material participation in the FREE download below.
Real property development or redevelopment
These are all of the activities involved in going from a blueprint for a property and turning it into reality.
An example would be our development project where we’re taking a plot of land and building two duplexes and a single family home. Right now it’s just an architectural drawing but eventually it will become an actual property.
Architectural drawing of our duplex development project
Some examples of activities that we counted as material participation was working with an architect to develop the site plans as well as designing the single family home and duplexes. We also worked with City officials to get the plans approved. For a more complete list, please refer to the download.
Construction or reconstruction
This one is pretty straightforward. Many in our community are familiar with construction projects because a primary focus is forcing appreciation. It’s one of the major components of The Fast FIRE System.
It’s unclear if you have to be the one actually doing the construction, i.e., swinging a hammer. Or can you count overseeing construction as material participation? Many of the CPAs advisors say that arranging for others to do the construction counts as well. So this means hiring and managing a general contractor, who leads the construction project.
Acquisition
This one is also fairly straightforward. This includes all of the time and effort spent searching for a property, putting in offers, going through the due diligence process, getting financing and closing on a property.
I think the most common question we get about this one is, do the hours spent on properties you don’t end up buying count as material participation hours? This one is a gray area but many of our CPA advisors say that in general, these hours do NOT count toward material participation.
Conversion
What is conversion? Despite a considerable amount of research, I still don’t have a great answer to this question.
For the purposes of this article, I’m going to define it as the activities involved in changing the use of a property from one purpose to another. For example, to date, we have converted over 1000 hotel rooms into multifamily units.
The activities involved in conversion overlap significantly with development/redevelopment and construction/reconstruction above, but there are several unique aspects of conversion projects. For example, when you are converting a hotel to a multifamily, you need to work closely with the City to change the zoning or use of the property. The change in use also probably comes with a different set of code requirements. So you’ll need to not only understand the requirements, but you’ll also have to price that into your conversion plan.
Rendering of a kitchen in a hotel to multifamily conversion project
Rental operation
Rental operations are all of the day-to-day activities involved in keeping your rental running.
For long-term rentals, this involves general maintenance, responding to tenant calls, dealing with emergencies like broken pipes.
If you’re self-managing your rental, this is probably one of the main ways our students accumulate material participation hours.
One question that often comes up is, can you have a property manager and still get material participation hours?
This is a point of debate among CPAs, though many of our CPA advisors say that as long as you’re involved in the operations of your property, the hours count towards material participation.
For example, there was one time when I got a call from my property manager about water in the crawlspace of one of our duplexes. It was Friday evening and their solution was to send someone out to the house on Monday. This didn’t sound like something that could wait until Monday so I stepped in, called our contractor and got him to take care of the issue that night. So the reality is, just because you have a property manager, doesn’t mean you aren’t involved in the day-to-day operations of your properties!
You get a lot of material participation hours when you have a flood in the crawlspace due to a broken pipe
Management
This is another vague term that likely encompasses many of the other activities on this list.
But perhaps the main gist of this one is overseeing your portfolio and managing your property managers, contractors, as well as other relationships like your lenders, insurance brokers, and investor real estate agents.
For example, we have a portfolio of over 150 doors or units, and we are also general partners on another 2,000 syndicated multifamily units. So there’s a lot of management decisions that need to be made. Just this past week, we decided to sell one of our larger properties, so we can trade up and buy a bigger property in a better area. We also decided to invest $500,000 to replace several roofs in an apartment complex. I also had several calls this week with our real estate lawyers, property managers as well as investor agents.
Leasing
This one is pretty straightforward. This involves finding tenants, doing showings and leasing up your units.
If you have a property manager, they’ll do most of the above, so your hours would be limited to determining the rental rates.
Some students of ours have gone out and found tenants on their own when their property manager had difficulty finding tenants.
So even with a property manager, you can find a way to accumulate material participation hours.
Brokerage trade or business
This category is another one of those categories where it’s not entirely clear what type of activities it involves.
All of the other activities above involve a property that you own. You’re either developing the property, renovating it or managing/operating it.
This one is an outlier because it doesn’t appear to pertain to your property at all. It seems to refer to being a real estate agent and the activities related to helping someone else buy a property.
This would suggest that being a real estate agent could help you accumulate material participation hours.
If this is true, could an agent who owns zero properties accumulate 500 hours as a real estate agent and count this towards material participation?
It’s unclear but you probably don’t want to hang your hat on that one. Ultimately the spirit of all of the other ones above is that you own the rental properties and you’re materially participating in the rental property business, making those activities go from passive to non-passive.
For the above reasons, I have also left this one off of the download.
Be sure to do THIS
As you can see, what counts as material participation can sometimes be vague and unclear.
So what should you do?
What we have been told by several CPAs boils down to two main things.
The first is, document everything. Even if you’re unsure if something counts as material participation, it doesn’t hurt to document it. It’s better to have a record of it and let your CPA or the IRS determine if it should count or not, rather than you making that judgment on your own.
Second is, accumulate more material participation hours than you need. If you can, strive to surpass the cut-off by a lot. So if you need 500 hours, go for 750 hours. Then, if 200 hours get wiped out because the IRS says they don’t count, you still have more than the required 500 hours.
Be sure to download our free List of Activities that May Qualify as Material Participation
Conclusion
While it’s helpful to know what activities count or not, ultimately, knowing that something absolutely counts vs doesn’t count probably doesn’t matter as long as you’re documenting everything.
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