Under The Tax Reform Act of 1986, losses generated by passive activities can only be used to offset income generated by passive activities. However, if a taxpayer materially participates in the trade or business, any losses generated are deemed not passive and therefore deductible against other income.
So what is material participation? Reg. § 1.469-5T(a).
- The taxpayer works 500 hours or more during the year in the activity.
- The taxpayer does substantially all the work in the activity.
- The taxpayer works more than 100 hours in the activity during the year and no one else works more than the taxpayer.
- The activity is a significant participation activity (SPA), and the sum of SPAs in which the taxpayer works 100-500 hours exceeds 500 hours for the year.
- The taxpayer materially participated in the activity in any 5 of the prior 10 years.
- The activity is a personal service activity and the taxpayer materially participated in that activity in any 3 prior years.
- Based on all of the facts and circumstances, the taxpayer participates in the activity on a regular, continuous, and substantial basis during such year.
Whether a taxpayer has materially participated in an activity is determined on a year by year basis. Additionally, a taxpayer is required to keep sufficient documentation to validate the amount of his or her participation in a trade or business activity each year.
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