Meeting the 100-hour significant participation activity test.

• Author: Graat, Brenda M.

Effective beginning in 2013, the Health Care and Education Reconciliation Act, P.L. 111-152, created the 3.8% net investment income tax imposed by Sec. 1411 to fund health care reform. Since this tax came into effect, taxpayers and their advisers have considered income tax planning methods to alleviate the additional tax due. Because passive activity income is generally subject to the net investment income tax, one strategy is to focus on the taxpayer's level of participation in an activity so that income may be characterized as nonpassive and thus not subject to the tax.

As defined under the passive loss rules, according to Regs. Sec. 1.469-5(f) (1), participation is considered to be any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity, where the individual owns (directly or indirectly) an interest in the activity at the time the work is done. The regulations have defined three levels of participation: active, significant, and material.

Levels of Participation

Active participation is the least-stringent test, in which the taxpayer does not need to have regular, continuous, and substantial involvement in the operations. Instead, a taxpayer is considered to actively participate if he or she makes management decisions in a significant and bona fide sense. This level of participation is beneficial for taxpayers who have a greater than 10% interest in rental real estate activities, with an opportunity to claim a loss of up to $25,000 from those activities (subject to phaseout based on adjusted gross income).

A harder-to-achieve standard is material participation. To be considered as materially participating in an activity, an individual must, under Sec. 469(h)(1), have "regular, continuous, and substantial" involvement in the activity. Temp. Regs. Sec. 1.469-5T(a) provides seven tests by which taxpayers can meet the material participation standard, one of which is that the taxpayer participates more than 500 hours in the tax year in the activity. Where taxpayers can meet the material participation standard for an activity (and, for rental real estate activities, where the taxpayer meets the real estate professional requirements of Sec. 469(c)(7) and the activity is a trade or business), their income will be characterized as nonpassive and not subject to the net investment income tax.

In between these two levels is significant participation, defined in Temp. Regs...