How To Materially Participate

If you actively manage your real estate investments they will not be considered “passive activities” by the IRS. You materially participate in an activity if you are involved in the operation of the activity on a regular, continuous, and substantial basis. If you meet the Material Participation Test the IRS allows tax deductions where rental losses EXCEED
rental income.

As long as a taxpayer participates in management decisions in a bona fide sense, he actively materially participated in the real estate rental activity. Activities include new tenant approval, rental terms, repairs, capital expenditures, etc.

Materially Participate Maximum Deductible Amount

If you or your spouse actively participated in a passive real estate activity, you can deduct up to $25,000 of loss from your activity from your non-passive income. You “actively materially participate” in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. These management decisions would include approving new tenants, deciding on rental terms, approving expenditures, reviewing expenses and similar decisions.

Phase-out of Deduction

You may deduct real estate losses of up to $25,000 against your other income if you qualify, but the allowance is phased out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000. The $25,000 limit gets phased out by $1 for every $2 that you earn over $100,000.

Click here to learn more about MAGI and the phaseout deduction

Using a Property Management Company

Using a property management company to manage your property does not prevent you from meeting the material participation test, but you must show that you or your spouse participates in management decisions such as those listed above.

Note that if you are going to use a management firm, be sure that you have your attorney check over the agreement you sign with the firm to see that it does not characterize you as not materially participating and thus prevent you from deducting any loss.

Minimum Interest In Rental Property

You do not materially participate in a rental real estate activity unless your interest in the activity (including your spouse’s interest) was at least 10% (by value) of all interests in the activity throughout the year.

Materially Participate Examples

– Laura lives in California and owns a house in Arizona that she rents through an agent. She sets the rental terms and gives final approval to any rental agreement. She also has final authority over any repairs ordered by the agent. She is an “active participant” and may claim the $25,000 rental allowance.

– Patrick is single and has $50,000 in wages, $1,000 of passive income from a limited partnership, and $2,000 passive loss from a rental real estate activity in which he materially participated. $1,000 of Patrick’s $2,000 loss offsets his passive income. The remaining $1,000 loss can be deducted from his $50,000 wages.

– Melissa is single and has a salary of $54,000. She has another $1,200 in stock dividends for the year and a $5,000 loss from a house she owns and rents. Melissa has advertised and rented the house to the current tenants herself. She also collects the rents and contracted out the repairs when necessary. Since Melissa actively participated in the rental property management, she can use the entire $5,000 loss to offset her other income.

If you are married and file a separate return and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the tax year and are filing a separate return, you cannot use the special materially participate allowance to reduce your non-passive income.