Summary: Have you taken advantage of the tax benefits real estate have to offer? If so, then you’re probably familiar with material participation. Material participation refers to the criteria that the IRS uses to determine whether a business endeavor is active or passive. It’s what makes the income from the business either an active or passive source of income. This is especially important in real estate. If you materially participate in real estate, you can use real estate losses to offset your W2 or 1099 income. People often get stuck on what activities qualify as material participation. In this article, I’m going to go over the major categories of real estate activity that count as material participation with a specific focus on vacation rentals. This article comes with a detailed download which contains a detailed list of activities for each of these categories.
[Disclaimer: We are not accountants, lawyers or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
If you’re a real estate investor, you’re probably already familiar with the tax benefits.
If you’re just getting started, then you’re going to want to learn about real estate professional status or the short-term rental tax loophole, which are two ways to use real estate to shelter your W2 of 1099 income.
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?
Note: In this article, we’ll be covering the specific activities for a vacation rental. We’ll cover the specific activities for a long-term rental in a future article.
Before we delve 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. Most real estate investors use the following three:
- 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 criteria, then your real estate activity will be 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. You can read more about the short-term rental tax loophole and real estate profession status by clicking on the links.
What Activities Count as Material Participation?
This is what tends to trip people up. And for good reason. The IRS doesn’t provide specific examples of what counts as material participation.
What they do provide in Sec. 469(c)(7) of the IRS code is the following list:
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 converting an idea from paper to a residential or nonresidential property.
An example would be our project to expand the footprint of our vacation rental. We’re taking a dingy, unused garage and we’re adding two new bedrooms and a bathroom. This expands our vacation rental from a 4 bedroom, 2 bath house to a 6 bedroom, 3 bath house. Right now it’s just an architectural drawing. But eventually it will become a real physical property.
Some examples of activities that count as material participation would be working with an architect to develop the building design. Other examples are working with the city to get the plans approved or working with the various utility companies to get utilities to the property. For a more complete list, please refer to the download.
Construction or Reconstruction
This one is probably pretty straightforward. We are all familiar with construction projects. Or for many in our community, reconstruction or renovations used to force appreciation.
Do you have to do the construction yourself for it to count as material participation? Many of the CPAs we’ve spoken to say that arranging for others to do them counts as well. So this means hiring and managing a general contractor. Who then sources the materials and hires/manages subcontractors.
Like construction, this one is also fairly straightforward. This includes all of the time and effort spent searching for a property.
Do the hours you spend on properties you don’t end up buying count as material participation hours? I think that is the most common question we get about this one. Which is a gray area. However, many of the CPAs we have spoken to say that in general, these hours don’t count toward material participation.
What is conversion?
It’s a good question. 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, this might involve converting an office space into a living space used as a vacation rental. Maybe you take a multifamily property and turn it into a boutique hotel-like property that you run as a vacation rental.
The activities involved in conversion likely overlap significantly with development/redevelopment and construction/reconstruction above.
Rental Operation Management
Rental operations include all of the activities involved in keeping the vacation rental up and running.
Some examples of activities include: addressing general maintenance issues, paying for utilities, property taxes and insurance, responding to messages from guests, and dealing with emergencies like broken pipes.
This is probably one of the main ways our students accumulate hours.
One question that often comes up is, can you have a property manager and still accumulate material participation hours?
This is a point of debate among CPAs. Although many of the CPAs we work with say that as long as you’re involved in the operations of your property, the hours count towards material participation.
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 property management.
So this would be the hours someone spends self managing the property.
You would be the primary contact for guests. You would also be the one coordinating directly with a handyman or contractor for any repair or maintenance issues that come up.
For a vacation rental, this would be interacting directly with the guest before arrival, during their stay and at check-out. You’d also be coordinating the cleaning and any maintenance issues.
This one may not apply for vacation rentals unless you consider booking guests as leasing.
If you have a property manager, they’ll be handling most of the above. As a result, your time will be fairly limited to things like determining the nightly rates for your properties.
So even with property management, you can find a way to accumulate material participation hours.
If you’re self managing, getting bookings is a great way to accumulate hours. This would entail listing your property on various online travel agencies like Airbnb or VRBO. You will likely have vacation rental software that serves as a channel manager to help coordinate bookings across these different sites. You will also likely have your own direct booking website, so there you’ll accumulate a lot of hours managing this site.
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? Then 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.
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?
According to multiple CPAs, there are two main points to focus on.
The first is, document everything. Even if you’re unsure if something counts as material participation, it doesn’t hurt to document it. Let your CPA or the IRS determine if it should count or not. It’s better than making that judgment on your own and being wrong.
Second is, accumulate more material participation hours than you need. If you can, far surpass the cut-off. So if you need 500 hours of material participation, go for 750. Then, if 200 hours get wiped out because the IRS says they don’t count, you still have more than 500 hours.
It’s informative to know what activities count vs not. However, 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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