Material Participation is Key to Declaring Passive Activity Losses

October 7, 2024 by Gordon Advisors

Passive activity losses for tax purposes typically depend on whether the taxpayer is a material participant in the activity. An important caveat is that a trade or business is not routinely classified as a passive activity even if the taxpayer does not materially participate. This highlights the importance of the Internal Revenue Service (IRS) definition of material participation. When taxpayers are planning to deduct losses from their trade or business, they do not want the loss amount constrained by the passive activity loss rules.

Material participation tests are designed to help identify the level of a taxpayer’s participation in the activity, as this defines how losses can be claimed for the tax year. Investment activity is deemed passive if a taxpayer’s participation pertains to investments that do not require much activity/intervention from the taxpayer.

The taxpayer’s involvement in the trade or business must be regular, continuous, and substantial in order for material participation to occur. The IRS designed seven tests to evaluate material participation. Suppose an investment meets the standards outlined in even one of the IRS’s material participation tests. In that case, the investment is classified as active, and tax rules for active participation losses would need to be observed. Four qualitative tests evaluate the taxpayer’s participation throughout the tax year. Two tests examine the taxpayer’s involvement in prior tax years. The final test evaluates facts and circumstances.

• A taxpayer who is an active material participant can deduct losses on their tax return
• Passive activity rules limit the deductibility of any passive losses

Losses are deducted from like taxpayer activity. If an investment requires active participation from the taxpayer, only losses from other active participation investments can be deducted. For material participation deemed passive, only losses from other passive activities can be deducted from the passive activity gains. If, for example, active participation investments gain income and the passive activity investments lose money, the losses from the passive activity cannot be deducted from the active participation gains, even if the same taxpayer owns both investments.

Typically, the owner of a limited partnership is considered an active participant if they can provide proof of 500 hours of participation during the tax year in question through appointment books, desk diaries, office records, etc.

Passive investment strategies are often implemented as a low-risk, longer-term option that requires minimal taxpayer involvement.

For answers to your questions about material participation, passive activity losses, or any other tax matter, contact a trusted tax professional at Gordon Advisors.