Introduction: Scope, Audience, and Why Material Participation Matters
This guide explains how material participation rules apply to real estate investors, especially those with high incomes, and why mastering these rules is crucial for optimizing your tax position. Understanding material participation in real estate is essential for investors who want to maximize deductions, minimize tax liability, and unlock the full potential of their real estate portfolios. Whether you own a single rental property or manage a large portfolio, knowing how to navigate the IRS’s material participation requirements can mean the difference between suspended losses and significant tax savings. This guide is specifically designed for real estate investors—particularly high-income individuals—who are seeking to optimize their tax strategies by leveraging the rules around material participation in real estate.
Why This Matters for High-Income Real Estate Investors
Most high-net-worth investors are sitting on six or seven figures of suspended losses they can’t touch due to not meeting the IRS’s material participation requirements for real estate. Not because they don’t qualify for deductions—but because the IRS classifies those losses as passive. The IRS applies passive activity rules to determine how income, expenses, and losses from rental and business activities are treated. These rules also affect other types of income, such as supplemental income reported on Schedule E, and apply to individuals, estates, trusts, personal service corporations, and closely held corporations.
Passive Activity Loss (PAL) Rules Overview
Under the Passive Activity Loss (PAL) rules, passive losses can’t offset W-2 wages, business income, or investment gains. Instead, passive losses can only offset passive income—meaning you can use passive losses to reduce your taxable income only from other passive activities, such as rental properties or certain investments.
That’s the game. But here’s the move:
If you understand how to qualify for material participation, you can reclassify those losses as non-passive—and use them to offset your active income. This is one of the few entirely legal ways to go from a six-figure tax bill to zero without offshore accounts or shell companies.
What the Passive Loss Rules Actually Say
By default, the IRS treats all rental activities as passive. That means your rental losses can’t offset active or portfolio income unless you prove you’re actively involved. In general, rental property generates passive activity income, which is income derived from passive activities like rental properties or certain business investments where you do not materially participate.
If you don’t materially participate, those losses are suspended—carried forward indefinitely until you sell the property or generate passive income to offset them. Taxpayers can carry forward suspended passive losses to future tax years if they do not have enough passive income to offset those losses in the current year.
Most CPAs will tell you to “just wait it out.” That’s lazy advice. The smarter move is to reclassify those losses through one of three exceptions.
The Three Paths to Escape Passive Status
1. Sell the Property in a Fully Taxable Transaction
If you sell your entire interest in a property, all suspended passive losses are released. Those losses can then offset any type of income—wages, dividends, or capital gains.
2. Qualify for the $25,000 Active Participation Exception
The $25,000 exception is available for active participants in rental real estate. The IRS allows a special $25,000 allowance for passive activity losses if the taxpayer actively participates in rental real estate activities, subject to income limitations based on adjusted gross income. To qualify for the special allowance, a taxpayer must be an active participant in the rental activity, which is a less stringent standard than material participation.
If your adjusted gross income (AGI) is under $100,000, you may qualify for up to a $25,000 offset for active participation. But it phases out entirely at $150,000 AGI, so most high-income earners don’t qualify.
3. Qualify as a Real Estate Professional and Materially Participate
Under Section 469 of the tax code, if you qualify as a Real Estate Professional (REPS) and materially participate in the activity, the losses are non-passive. Rental real estate is generally considered a passive activity, meaning losses can only offset passive income, unless material participation is established. The IRS defines a real property trade or business as one that involves developing, constructing, acquiring, converting, renting, operating, managing, or brokering real property, including real property development. To qualify as a real estate professional, individuals must perform more than 50% of their personal services in real property trades or businesses in which they materially participate, and must also perform more than 750 hours of services during the tax year in those activities. Only trade or business activities in real property count toward the REPS test.
A taxpayer who qualifies as a real estate professional must establish material participation in each separate rental activity for those activities to be considered nonpassive. Taxpayers who materially participate in a rental real estate activity may be able to avoid the passive activity loss limitations altogether. Qualifying as a real estate professional allows individuals to deduct rental real estate losses against nonpassive income, avoiding passive activity loss limitations. Special rules may apply for those who are married filing separately when determining qualification. This is the most powerful strategy used by advanced real estate investors we work with at Bennett Financials.
The Back Door: Short-Term Rentals and Material Participation
If you operate short-term rentals (STRs), you may not even need to qualify for REPS. Under the tax code, if the average period of customer use is seven days or less, the activity is not considered a rental—which means it’s not passive by default.
Material participation means you are involved in the operations of the activity on a regular, continuous, and substantial basis. The IRS uses specific material participation tests to determine if your short-term rental activity qualifies as a business activity or for nonpassive treatment. These IRS tests are performed annually to assess whether you are a material participant in your business, trade, or rental activities.
You still need to materially participate, but you don’t have to meet the REPS 750-hour or 50-percent rule. For busy executives or business owners, that’s a major advantage.
If you manage your own STRs, spend at least 100 hours a year on them, and no one else works more hours than you, you can deduct all the related losses against your active income. If you spend more than 100 hours but do not materially participate, your activity may be classified as a significant participation activity, which can affect whether your rental income is treated as passive or nonpassive.
One warning: hours spent managing STRs don’t count toward REPS. The Tax Court has confirmed this multiple times, so don’t blend the two strategies. For more details, see Fit Small Business – Short-Term Rental Tax Rules Explained.
Material Participation: The Core of the Strategy
To convert rental losses into deductions against active income, you must materially participate in the activity.
To qualify as a material participant, a taxpayer must demonstrate regular, continuous, and substantial involvement in the activity. The IRS uses Material Participation Tests to determine a taxpayer’s significant, ongoing, and consistent engagement in activities that generate income.
That means you’re involved on a regular, continuous, and substantial basis. To be considered a material participant, you must participate materially in the day to day operations or day to day management of the real estate activity.
Common Material Participation Tests
The IRS employs seven material participation tests to assess whether an individual qualifies as a material participant in various business, trade, or rental activities. Material participation is generally only confirmed if at least one of the seven material participation tests is met, and the IRS performs these tests annually to determine if a taxpayer materially participates in their rental activities. Taxpayers looking to qualify for material participation will need to keep detailed records and furnish written evidence to substantiate their qualification claim to the IRS, including the number of hours of material participation in an activity.
The most common three are:
- You participate more than 500 hours during the year.
- You do substantially all the work on the activity.
- You participate for more than 100 hours and no one else does more.
If you own multiple rentals and don’t make a grouping election, you must meet one of these tests for each property individually. That’s where many investors get tripped up.
At Bennett Financials, we often recommend filing a grouping election to treat all rentals as one activity. Taxpayers with an ownership interest in a venture receive participation credit for work done for it, based on records they maintain. That makes it easier to prove material participation in total, but it’s a permanent election—so consider the long-term effects before filing.
Day to day management and day to day operations of rental properties count toward material participation, and keeping contemporaneous daily time reports is the most credible way to document hours. Taxpayers looking to qualify for material participation will need to keep detailed records and furnish written evidence to substantiate their qualification claim to the IRS, including the number of hours of material participation in an activity.
For a deeper explanation, see the Fractional CFO Guide on the Bennett Financials site.
Material Participation Tests: How the IRS Decides
The IRS uses a set of seven material participation tests to determine whether your involvement in a rental real estate activity is substantial enough to treat your income as non-passive. These material participation tests are the gatekeepers for unlocking valuable tax benefits, including the ability to offset active income and avoid the net investment income tax on rental income.
For real estate investors aiming to qualify as a real estate professional, it’s not enough to simply own property—you must prove that your participation in real property trades or businesses is both regular and significant. The most common tests include spending more than 500 hours on the activity, doing substantially all the work yourself, or participating for more than 100 hours with no one else contributing more. For those seeking real estate professional status, you must also spend more than 750 hours per year in real property trades or businesses, and more than half of your personal services for the year must be in these activities.
Understanding and applying these material participation tests is essential. If you don’t meet the criteria, your rental real estate income remains passive, subject to the passive activity loss rules and potentially the net investment income tax. But if you do, you can reclassify your rental activity as non-passive, allowing you to use losses to offset other income and optimize your tax position. For high-income real estate investors, mastering these tests is a cornerstone of effective tax strategy.
Personal Service Hours: Tracking Your Time
When it comes to proving material participation in rental real estate activities, meticulous tracking of your personal service hours is non-negotiable. The IRS expects detailed, contemporaneous records that clearly document your substantial involvement in real property trades or businesses. This means keeping calendars, appointment books, spreadsheets, or even narrative summaries that outline the hours spent on qualifying activities.
What Counts as Personal Service Hours?
Personal service hours include time spent managing tenants, negotiating leases, arranging financing, overseeing repairs, and making key management decisions. These activities demonstrate your hands-on role and help establish that you materially participate in your rental real estate. The more accurate and thorough your records, the stronger your case if the IRS ever questions your material participation.
By diligently tracking your hours spent on each property or across your portfolio, you not only protect yourself in the event of an audit but also position yourself to claim valuable tax benefits. Substantial involvement, backed by solid documentation, is the key to unlocking non-passive treatment for your rental activities and maximizing your tax deductions.
Multiple Properties: Aggregation and Grouping Rules
If you own multiple rental properties, the IRS allows you to aggregate or group your real property trades or businesses to meet the material participation tests. This strategy can be a game-changer for real estate investors who might not meet the participation threshold on each property individually but easily qualify when their hours are combined.
How Grouping Elections Work
By making a grouping election, you can pool the hours spent across all your rental activities, helping you satisfy the 750-hour test or the requirement that more than half of your personal services are in real estate. This approach not only simplifies compliance but also increases your chances of qualifying as a real estate professional, which can unlock significant tax benefits like the 20% qualified business income deduction and shield more of your rental income from the net investment income tax.
However, aggregation and grouping come with their own set of rules and long-term implications. Once you elect to group your properties, the decision is generally permanent, and you must apply the material participation tests to the group as a whole. Understanding these rules is essential to avoid missteps that could trigger passive activity loss rules or limit your ability to offset other income. For investors with multiple properties, strategic grouping is a powerful tool for maximizing non-passive income and optimizing your overall tax strategy.
Real-World Examples
Drogo: He spends 1,100 hours brokering real-estate deals and qualifies for REPS. But he doesn’t spend time managing his own rentals. His losses remain passive
Jon Snow: He manages properties for others (300 hours) and spends 500 hours on his own rentals. Even without REPS, Jon materially participates and can deduct his losses against active income.
Takeaway: REPS opens the gate, but material participation gets you through it.
Short-Term Rentals: Schedule C vs. Schedule E
Short-term rentals aren’t automatically treated the same. The distinction depends on how you run the business:
- Schedule C (subject to self-employment tax): You provide substantial services such as daily cleaning, meals, or concierge support. Income reported on Schedule C is treated as ordinary income for tax purposes, and if the rental activity is conducted in the ordinary course of a trade or business, it may affect how the IRS classifies the income and applies certain taxes.
- Schedule E (not subject to self-employment tax): You manage the property yourself without hotel-like services.
The sweet spot for most high-income investors is a Schedule E short-term rental that’s not passive—no self-employment tax, no REPS requirement, and full deductibility.
Cost Segregation: The Force Multiplier
Once your rental activity is non-passive, cost segregation can dramatically accelerate your deductions.
Cost segregation breaks a property into components—like flooring, lighting, and landscaping—with shorter useful lives. Instead of depreciating the whole building over 27.5 or 39 years, you can deduct parts of it over 5, 7, or 15 years, often with bonus depreciation in the first year. Depreciation deductions allow you to shelter income by creating paper losses, which can be used to offset other income if you materially participate in the rental activity, making them a powerful tax planning tool.
For example, buy a $1 million property and a cost-seg study identifies $300,000 of 5- and 15-year assets—you can deduct that entire $300,000 in year one. The value of the property and its components for depreciation purposes is determined based on fair market value.
If your activity is non-passive, those deductions directly offset your active income. That’s a six-figure tax reduction in year one. The One Big Beautiful Bill Act reinstated full bonus depreciation and the qualified business income deduction, further enhancing tax benefits for short-term rental owners.
To learn how this works in practice, check out Cost Segregation Tax Strategy on the Bennett Financials blog, see how NuSpine Chiropractor used strategic finance to scale, exit, and reinvest, and manage cash flow effectively in your service business.
Stacking the Strategy: 1031 + Cost Seg + Material Participation
Here’s how experienced investors layer these tools:
- Use cost segregation to front-load depreciation and create large losses. Losses must be determined using a reasonable method for grouping activities and identifying each income producing activity.
- Reclassify the activity as non-passive through material participation.
- Before depreciation recapture kicks in, execute a 1031 exchange.
- Roll the gain into a new property with equal or greater value in depreciable components. Taxpayers must apply at-risk rules before passive activity rules when determining allowable losses from an activity.
Repeat the process over time. Upon your death, your heirs receive a stepped-up basis—erasing the deferred gains entirely. That’s how wealthy families compound tax-efficient generational wealth
Common Pitfalls to Avoid
- Using property managers: If someone else handles operations, you likely don’t materially participate.
- Forgetting to group properties: You’ll need to qualify separately for each one, which creates a compliance headache.
- Poor documentation: Without logs and records, you’re audit bait. The IRS wins when taxpayers “estimate.” Reviewing financial statements and maintaining accurate financial statements are important parts of substantiating material participation. Taxpayers need to keep records of the number of hours of material participation in an activity and be able to provide written evidence if needed.
We recommend using Tax Smart Investors to track hours and maintain audit-ready documentation. Our team builds similar systems for Bennett Financials clients to keep every deduction bulletproof.
Bottom Line
If you’re earning over $500K a year and still treating your rentals as passive, you’re paying too much tax.
You don’t need to restructure your life or set up complicated entities—you just need the right tax strategy executed the right way.
Whether through Real Estate Professional Status, material participation, cost segregation, or a short-term rental structure, these are legitimate, proven tools used by sophisticated investors for decades.
Ready to keep more of what you earn? Start by fixing your tax classification and optimizing your structure. Book a consultation with Bennett Financials and let’s turn your rental losses into real cash flow.
Key Takeaways
- Material participation turns rental losses from passive to non-passive
- Short-term rentals under seven days often qualify automatically
- Grouping elections simplify qualification but are permanent
- Cost segregation amplifies the impact of non-passive status
- Accurate documentation protects you in an IRS audit
