Material Participation - an unexpected trap

[Bruce D. Kowal]

As some readers of this Forum know, there are two types of participation for those seeking the use of real estate losses: Active Participation and Material Participation. For REI over a certain income limit, in order to use those losses to offset their salary income, they want to wear the Badge of Real Estate Professional.  And that's the easiest way to communicate this:  you want to meet the requirements to wear that Badge on your lapel collar.  Or on your ballcap.

Once you have that Badge, then you look at how many hours you are spending on your properties.  This is the broad view, ignoring for now the details of IRC Sec 469 (c)(7) and the associated Regs.

Now, getting that Badge means you have to have some involvement in the real estate business. Again, this is a broad description. A common way to get that Badge is to already be active in the real estate business. You may be the Owner of a Management Company, for example. Or you may be a salaried employee of an REIT, or local real estate developer. Now, pay attention: that work you perform as a salaried employee does count towards earning that Badge, BUT, and this is a big BUT:  you must be a 5% shareholder of the company paying you that salary.  IRC Sec. 469 (c)(7)(D)(ii)

Why?  The Code was amended early on in response to complaints from people who already were in that business.  They had "skin" in the game.  What Congress did with the 5% rule was to prevent someone, with no skin in the game, from benefiting simply by virtue of being an Employee.

At least that's how I read this.  

An exhaustive discussion can be found in the District Court decision in Stanley et al v. United States [W.D. Arkansas 2015].  This is a fascinating case, where all the requirements surrounding the Material Participation requirements are discussed.  Real cases, with real facts, are always easier to understand than an article which simply parses the Code and Regs.  Simply put:  any intelligent investor can read this and understand the issues.  And if you are on Bigger Pockets, you already have those mental attributes.

Are there any work arounds?  Sure there are.  I know of several.

What if you have already filed tax returns based upon being a salaried employee (with no ownership) and deeming that to help you get that Badge?  Well, now you have a problem.  To be sure.

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