Material Participation v. Passive Participation in a rental property

With everything going on with the eviction moratorium on renters, this has thrown many landlords into a tailspin. Many landlords are incurring losses because of there is no revenue from the property yet still have continued expenses. If your rental property shows a loss for the year, you want to deduct that loss against your other income.

That’s just basic accounting 101 gross income- expenses = net income.

In the good ol’ days (before the Tax Reform Act of 1986), you always did that. When you did that, your after tax rate from the rental increased. With the loss deduction, the government helped you grow your rental property profits. You still can use the loss deduction benefit on your rental properties if you can jump over the passive-loss hurdles.

Wait, what is passive participation and therefore passive loss?

A passive loss is a financial loss within an investment in any trade or business enterprise in which you are not a material participant.

Something of note on passive loss

Passive losses can come from rental real estate, in which the taxpayer has no material participation.
A taxpayer can write off passive losses against passive gains.
To claim passive losses, the taxpayer needs to use IRS Form 8582: Passive Activity Loss Limitations.

Materially Participant

Most landlords qualify as material participants in their own rental properties. (That’s a good thing!) Being an active participant allows for all expenses to be deducted against the income of your rental property.

There is a guideline as to what constitutes a material participant.

There are 7 qualifiers, but only one needs to be met to be considered.

Qualifiers:

Participation for more than 500 hours.
Activity that constituted all participation substantially.
Involvement for more than 100 hours and no less than the participation of any other individual.
A participation activity is a business in which the taxpayer participates, without qualifying for any of the other six tests, for more than 100 hours.
Participation during any five of the preceding ten taxable years.
Which is a personal service activity for any three prior taxable years.
- Personal service activities are activities in which capital is not a material income-producing factor.
More than 100 hours and based on all the facts and circumstances, on a regular, continuous, and substantial basis.

The good, the bad and the ugly.

The good: all losses are deductible i.e. unpaid rent

The bad: Delegating work to others, or purely managerial roles are not considered

The ugly: As easy as one qualifies for materially participating, one can ‘unqualify’

Show me the money, or in this case time logs!

How to show you are a material participant? Keep a log of everything that you do for the property.

In other words, DOCUMENT, DOCUMENT, DOCUMENT!

That way if you ever run into an issue with the IRS you have proof required.

What happens if you do not qualify as a Material participant in the rental property?

The property in question becomes a passive income as is subject to different guidelines for deduction. Fear not! All is not lost, there are still ways to report your losses.

If in following years, you do pass the material participation tests on a property, the accumulated losses on that property is deductible.
In future years, you can use the losses against passive income from other passive activities.
The year the property is sold, you may deduct the total accumulated passive losses.

What to do to protect yourself and your interests

One of the best ways to protect yourself, is to create a company in which the property in an asset. If the property is under your name, you could be liable if anything happens in the property. The company will limit your liability. Also you can run all the property expense through the company. (Woo Hoo!)

Shameless plug: We can help with that! Contact us as info@cdprofessionalservices.com to find out how.