Ep. 158 | Material Participation Demystified
Download MP3Hey, everybody, and welcome back to the teaching tax flow podcast today episode 158. We are gonna demystify material participation. What that means and what that doesn't. But also, before we get into it, let's take a brief moment and thank our episode sponsor.
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John Tripolsky:Alright, everybody. We are back here again on the teaching tax flow podcast. As you've seen in the title, read in the show notes, hopefully, you can see or read one of the two, hopefully, both. But we are gonna answer that question, right, of what is, or I should say, we are gonna demystify what exactly material participation is and is not as always, but we gotta welcome him back, I guess. Chris Pacquero, welcome back to your own show, sir.
John Tripolsky:What's happening, bud?
Chris Picciurro, CPA:It is an honor to be back. I'm so excited about our guest today. We're going to demystify a concept that's extremely challenging for taxpayers, especially business owner and and real estate investors to understand and to grasp. And we our guest today is a huge overachiever in a positive way. We talk about tax professionals, and and we we hold both enrolled agents and CPAs in such high regard.
Chris Picciurro, CPA:But he has both those designations. So this that's pretty sweet. And and and we're excited to have him. He also hosts his own podcast. We're gonna talk about but, I'm excited to welcome Jeremy Wells to the Teaching Tax Flow podcast.
Chris Picciurro, CPA:Thank you so much for joining us.
Jeremy Wells, EA, CPA:Thank you. It's really an honor and privilege to be here. I've loved the show, love, what you're doing to help spread the word about good ways of approaching taxes and tax strategy for taxpayers out there. There's a whole bunch of junk information out there, and, you know, we can't really shut it down. All we can do is fight against it with good information.
Jeremy Wells, EA, CPA:So thank you for putting this out there.
Chris Picciurro, CPA:Our pleasure. And I had I had the pleasure of meeting Jeremy in Florida, actually, at at a taxposium conference about a year year and a few months ago. And, you know, and and that was great. I know he's a resident of of Northeast Florida, so it was a quick little jump over to Orlando. And it was in July, so we were pretty much staying inside at that point.
Chris Picciurro, CPA:Yep.
Jeremy Wells, EA, CPA:You know? Absolutely. You gotta stay in the in the air conditioner here in Florida in the summer, especially in Orlando. It the the humidity is is just not worth going outside during the middle of the day there.
Chris Picciurro, CPA:Well, Jerry, before we jump into material participation, can you give us a little bit of more information about your journey? I and and what I really love about your podcast and the work you do, is that that you came from academia. Right? So so and and now you're taking that into practice. So I feel like your advice is very academically sound or research sound even though you might but but also practical.
Chris Picciurro, CPA:Practical.
Jeremy Wells, EA, CPA:That's well, thank you. That's what I that's what I aim for. So I that's right. I straight out of undergrad, I had my sight set on law school, actually, but that changed. A few friends of mine from undergrad who were a year or two ahead of me, they came back to campus to visit, told me how great grad school is.
Jeremy Wells, EA, CPA:I had always wanted to teach, Teaching is is in my roots, and so looked at grad school, decided teaching would be the right path for me, and so went to grad school. I spent six years at LSU. If I'd gone somewhere a little less fun than Baton Rouge, I might have gotten done a little quicker. I probably should have gotten done in four or five years, but, you know, that's okay. Baton Rouge was a good place to spend six years.
Jeremy Wells, EA, CPA:But got a PhD in political science, taught at Texas State University for five years, taught international relations actually. So how how am I an accountant now? We'll
Chris Picciurro, CPA:go
Jeremy Wells, EA, CPA:back to originally the plan was law school. And so I had taken a couple of business law classes, and along with that, a couple of accounting classes because I thought I was gonna minor in business. I wanted to focus on contract law, the business side of law. So when I was thinking about, you know, the future with my wife, especially around the time my daughter was born, 2017, looking at career prospects in academia, and it just it just wasn't there. You know, really, the academic job market has always been tough, but really especially since the Great Recession.
Jeremy Wells, EA, CPA:That's been a really tough job market, and I was looking for something that not only would have better job prospects, but something where I might have a little bit more independence. You know, not not have to clock in and out five days a week and commute to work. So thinking back to some of the things I had studied in college that weren't what I was doing and thinking about those accounting courses, I actually did pretty well in them, found it interesting. The university I was teaching at had a decent accounting program, so I talked to some of the faculty there. I also started reaching out to CPAs online and in person, met a bunch of great ones, decided this is probably the way I wanna go, and one of them recommended looking at the enrolled agent license, sort of a quick, a little bit quicker way, not an easier way, but a quicker way to get into the profession.
Jeremy Wells, EA, CPA:So I started doing that, and in the meantime, started working on the CPA, got that a couple years later, and have been doing this for seven or eight years now, and not looking back. Love it.
Chris Picciurro, CPA:Well, I the positive of of being a LSU Tiger is you you've typically are gonna have good football, really good baseball. Yep. Hit or miss on basketball, but that's alright.
Jeremy Wells, EA, CPA:That's okay. That's okay. Yep. Absolutely.
Chris Picciurro, CPA:You got the two big ones. I mean, they love their baseball is my favorite sports, and they love their baseball down there, and I appreciate that.
Jeremy Wells, EA, CPA:And as a grad student, because I was a student, I had the same access to all of that as every other student, but because as a grad student I had seniority over all of the undergrads, so we basically got our pick of season tickets to the football games, and then it was free admission to all the other sports. So I I I went to the box to watch a lot of LSU baseball games for sure. Wow.
Chris Picciurro, CPA:Yeah. Well, we know you live in Gator Country now, so we'll we'll we'll we'll but but
Jeremy Wells, EA, CPA:That's right. That's right. Yeah. When you know, settling down, wife and kid, the the the sports thing become a lot it became a lot less of an important factor, in in life. But, yeah, I still can't I I catch up with what's going on there a little bit every now and then.
Chris Picciurro, CPA:Awesome. Well, let's jump into material participation. Gil, this is something that I find challenging to explain, to a a a few different segments of taxpayers. Taxpayers. Number one is gonna be your your real estate investors that that ultimately the that run into what I call passive activity loss rules.
Chris Picciurro, CPA:The other one are people that invest in in partnerships in a limited capacity. And, ultimately, people that have losses that are on their tax documents, but they don't get to deduct them in their current year. That's about as simple as I could say. Those are the people that in fact, can you kinda talk about a little bit about what material participation is?
Jeremy Wells, EA, CPA:Yeah. It's always a fun conversation. And by fun, I mean not fun. When you prep a return for real estate investor, and now you have to explain why they're still paying taxes even though they thought they had all these losses that they could take for the year. So, yeah, the the gist here, right, is that you you should not be able.
Jeremy Wells, EA, CPA:Right? And and this is debatable. Right? I'm not I'm not taking a position here. I'm just saying this is what the law says.
Jeremy Wells, EA, CPA:Right? The the gist here is that you should not be able to offset active income. So your your wages basically, you know, along with some other stuff. Your wages with income that is from activities that you didn't really put as much work and effort into. Now, what we mean by work and effort is gonna be important because even though it feels like you put a lot of work and effort into something that is by definition a passive activity, that may not actually qualify when we're talking about what material participation is.
Jeremy Wells, EA, CPA:Right? So that's that's why, you know, that's important. We first have to make that distinction between passive and non passive income in terms of thinking about whether you're to be able to take those losses or not. And of course, the goal here, you know, you're the taxpayer, is to try to have that active income being offset with those passive losses. You work and you earn money, you want to have some paper losses that you can offset that with, reduce your tax liability.
Jeremy Wells, EA, CPA:Totally understandable. Alright. So how do we know if you can do that? And the, what we have is honestly one of the most complicated code sections, right, in all of the tax code. And one of the most complicated sets of regulations that goes along with that.
Jeremy Wells, EA, CPA:But it all comes back to section four sixty nine of the tax code and that these are the passive activity loss rules. And that's all it is. And so that's what tells us in print whether or not you're able to actually take those passive losses and offset your active income with that. And we, you know, we as the tax professional, we're reading through that. We're breaking that down.
Jeremy Wells, EA, CPA:We're trying to figure out if there's any way we can squeeze some of these rules and apply them to your actual passive income. And and the trick here, the key, right, is to materially materially participate. Basically, take that passive income and you do the right kind of work, and you do enough of that work throughout the year to make it to where even though it's still passive, it's now actually non passive and we can't offset your active income. So basically, a lot of the questions we're asking real estate investors, but then also business owners and investors when it comes to the pass through income they're getting. So if you're a partner in a partnership or a shareholder in S corporation, even if you're even if it's not real estate focused, right, that that business, because you're an investor who's not maybe directly involved in the day to day operations, you don't actually work for the company, you're not one of the leaders of the company, you're just an investor and you just put some money into it, that's by definition going to be passive as well.
Jeremy Wells, EA, CPA:So it's beyond just real estate, right? We we've got a lot of taxpayers out there who find themselves with this passive income. And, you know, honestly, they they get a little confused by that. Right? They feel like, you know, they they've done enough to earn being able to take advantage of those passive losses.
Jeremy Wells, EA, CPA:And sometimes we have to have a hard conversation with them about that.
Chris Picciurro, CPA:Absolutely. And that's that's where, people have to understand one of the three laws of teaching tax flow. Tax laws are written. I mean, tax agencies are involuntary business partner. Tax laws are written to encourage and discourage certain behavior, meaning just buying a short term rental property, just investing in oil and gas, for instance, just buying a rental prop buying investing in an apartment complex, even if your rep status doesn't guarantee you that you're going to be able to deduct those losses on the current year tax return.
Chris Picciurro, CPA:You have to have material participation, under section four sixty nine. But the IRS is friendly enough to give us some tests.
Jeremy Wells, EA, CPA:Yep. Yep. And and they're certain. Right? Like, they they you know, so so this comes out of, like I said, the the regulations, and this is it it's complicated.
Jeremy Wells, EA, CPA:Right? There's a lot to this. We're we're up to I wanna say there's about a dozen different regulations just under this one code section. Right? And in particular, one of them, five t, the t stands for temporary.
Jeremy Wells, EA, CPA:And believe it or not, they've been temporary for a couple decades now. Right? Like, they they they're they're about as close to permanent as you can get and still be temporary. But anyway, that is where we have the the seven tests. And for the most part, most taxpayers are really only gonna look at two or three of these.
Jeremy Wells, EA, CPA:A couple of them are there. They're just not applicable to most of the taxpayers that we're gonna work with. Depending on what you're doing in that activity, and and in this case, like to use the word activity because it could be, like I said, you've invested in a partnership. It could be that you own a rental. It could be that you're a passive shareholder or you're a silent shareholder in an S Corp.
Jeremy Wells, EA, CPA:Right? All of these are passive activities for the purposes of four sixty nine. So, you know, is your participation in this activity going to rise to being material and therefore unlock those losses and make them non passive for you. And so yeah, it's just a question of looking at those seven tests. And like I said, really, you know, we start with the first two or three.
Jeremy Wells, EA, CPA:Those tend to be one, the easiest to track and the easiest to document and make a good solid case for, we always come back to substantiation, especially in these kinds of things. Remember, we're taking a position that by definition is not generally the rule. Right? The the general rule is passive losses can offset active income. Now there's always the exception to the rule.
Jeremy Wells, EA, CPA:The exception to the rule is if you materially participate in that passive activity, you might be able to offset that active income. So if there's ever a question, right, the default position is, no, you can't do that unless you've done these things. You've met one of these material participation tests. So we always wanna try to document that as much as possible just in case there's ever a question about that.
Chris Picciurro, CPA:It's yeah. If you and if you're listening to this and watching it, think about this. Think about these losses being like a like a handicap parking spot. By default, you can't just pull your car into the handicap spot. It's there for people that actually need it, like my dad.
Chris Picciurro, CPA:That's why I like kinda like traveling with my dad. Save some stuff. But but but it's there for people that need it legitimately. So if you're illegitimately parking in it, there's the the penalties are significant. Your car is gonna get towed.
Chris Picciurro, CPA:There's not a 100% chance you're gonna get caught, so we never advocate doing anything unethical. But, but if you if you meet one of the tests, I e, you either have a temporary handicap permit or a permanent handicap permit, slide your car in there and go about your business. And that's that's kind of the way I think about that situation.
Jeremy Wells, EA, CPA:Absolutely. Absolutely. I think that's a great analogy. You know, it's something that every now and then, and we hate to do that, you know, we're not looking to enforce, you know, as your as your tax professional, as your tax adviser, your tax return preparer, we're not looking to enforce the rules. We're looking to help you make sure that you're following the rules as much as possible.
Jeremy Wells, EA, CPA:And so when we, you know, ask you for information or when we downright insist on information, we're doing that, yes, there is part of that to protect ourselves because we can't prepare a return in a way that could be considered incorrect, and then therefore that's going to cause problems for us as the preparer. If we have, you know, signed our name on that return as the preparer of that return
Chris Picciurro, CPA:Mhmm.
Jeremy Wells, EA, CPA:There's a potential for us to have, you know, some problems with the IRS with that return if we put something on there that isn't true. But you as our client, you know, we're looking out for your best interest. We don't want you to wind up in a fight with the IRS and you don't have the information and especially the documentation to support the position that we took on that return for you.
Chris Picciurro, CPA:Correct. I I saw a return this person has real estate professional status, rep status, but they invested in a limited part or they invested as a limited partner in an apartment syndication. They don't have material participation, and they own 3%. And the previous preparer let them take that entire loss. Loss.
Chris Picciurro, CPA:And it's like you know? So so that that's that's a that's a problem. Of those things.
Jeremy Wells, EA, CPA:That's a problem.
Chris Picciurro, CPA:The problem. So as the so you just inform them and and, you know, say you you should amend this return. But so my my point is and this is where I think and I I don't I'd like to know about your experiences. I feel like and we're pretty heavy in real estate on our private practice. Real estate professional status doesn't just give you a green light to write off any type of real estate investments.
Chris Picciurro, CPA:You still need to meet one of these, material participation tests and have some type of ownership too. Like, in in the hours, you know, this isn't necessarily an hours discussion, but but in you know, sometimes someone will say, well, I work at a I work as at a real estate brokerage. I'm the office manager, so I have seven hundred and fifty hours in real estate. You might, but you don't own any of that brokerage. So there's there there are rules.
Jeremy Wells, EA, CPA:Yep. Yep. And and that's that's always a fun thing to because I live in Northeast Florida. And, you know, the first few years when we moved here, I was reaching out, finding a lot of clients locally. And Northeast Florida real estate market has been relatively hot, you know, and growing for a At one point during the pandemic, I saw a statistic somewhere that there were at one point more real licensed real estate agents than there were homes for sale on the market.
Jeremy Wells, EA, CPA:Like, it's, you know Right. I I think that shifted, you know, over the last year or two. But it's it's it's a lot here.
Chris Picciurro, CPA:And
Jeremy Wells, EA, CPA:I've gotten a lot of clients and a lot of questions about what exactly is that concept of real estate professional. I've got a real estate license. Does that mean I'm a real estate professional? I own x number of properties. Am I a real estate You know, like, your example, I work in a brokerage.
Jeremy Wells, EA, CPA:Does that make me and it's one of those things where the the way we just in common language would use a term may not be the way tax law specifically defines that term. And this is one of those cases. Right? Just because you have a real estate license doesn't make you a real estate professional for tax purposes necessarily. There's more that you've gotta be able to show there.
Jeremy Wells, EA, CPA:So it's really important to understand what those rules are and, you know, ideally, for me, work with a tax adviser who knows those rules and can advise you on them.
Chris Picciurro, CPA:Right. And we did I think we're gonna redo a little content because we you know, being a realtor doesn't make you a rep status.
Jeremy Wells, EA, CPA:Yeah. Exactly.
Chris Picciurro, CPA:But you could be rep status without being a realtor.
Jeremy Wells, EA, CPA:Absolutely.
Chris Picciurro, CPA:So you there are different kinds of now your activity as a realtor, depending on what activity you are what activities you're participating in, especially if you're a broker or maybe you those hours could count. It's just a matter of it's just you know, it's it's tough. And
Jeremy Wells, EA, CPA:And I and I've had situations where I've had clients that they they went and got a real estate license. They spent a lot of time, and and even a lot of time that would qualify as material participation into their real estate activities. They started putting together a portfolio. The whole time, they kept their w two job though. And that's always a problem, right, for for people looking to be considered for tax purposes a real estate professional, because it makes it really, really difficult, if not virtually impossible, to make the claim that you spent at least half of your working time in her real estate profession.
Jeremy Wells, EA, CPA:Right? And so you've got a w two with six figures coming out of, you know, the investment firm that you work for or for the, you know, tech startup that you work for or whatever it is, you know, that that that can be a deal breaker, and it usually is. So it's really important to understand all the rules and not just assume based on what the label is that you've met those qualifications.
Chris Picciurro, CPA:Well, when we develop which I've been telling John kinda tongue in cheek, when we develop the teaching tax flow dating app, there's gonna be swiping going on. Hey. I'm a rep status. Okay. I wanna I wanna find that sugar daddy or sugar mama w two or, oh, you have got some activity losses?
Chris Picciurro, CPA:I'm about to exit my business. Let's get together.
John Tripolsky:I could see it now. Like, you're there's the the toolbar. Right? You're you're squeezing it out one end or the other on how much you need. Right?
John Tripolsky:That's the real match. And then the photo comes afterwards. Right?
Jeremy Wells, EA, CPA:So Absolutely.
Chris Picciurro, CPA:As far could you give us a couple tips as we if it's kinda wrap up on the practical side of of of maybe tracking hours, how it works when you have two spouses. Maybe can those hours be be combined at all? And just some practical, again, practical tips. And we've we've got a a shameless plug by one of the podcast sponsors is Reps Tracker, which is an app I've used that that helps you track all this, but you still got you know, you don't have to use an app. You could have
Jeremy Wells, EA, CPA:a spreadsheet if it's documented properly. So what what are some of the hacks that you can give us? Yeah. A 100%. And that that's always what I recommend whether, you know, you're talking about tracking your material participation in your rental portfolio, whether you're talking about tracking your income and expenses for your business, whether you're talking about tracking your mileage.
Jeremy Wells, EA, CPA:Right? There's an app for that. Right? That's that saying that's been around for, you know, what? When they introduced the iPhone, you know, eighteen years ago now.
Jeremy Wells, EA, CPA:You know, we've been we've been saying there's an app for that. And there is, and you know, we we're always going to push for that because it simplifies things. But in the meantime, just start off with spreadsheet. Right? And when you get sick and tired of doing it in that spreadsheet because you feel like you're constantly in that spreadsheet logging this stuff, that's that's when it's time to look at the app.
Jeremy Wells, EA, CPA:Right? Until then, use the spreadsheet because not only does that save you the cost of having to subscribe to another app. Right? But it also forces you to sit there and think about, okay, what am I actually documenting here? What is actually important?
Jeremy Wells, EA, CPA:What do I actually need to be tracking? And as you manually enter, you know, each one of those rows into that spreadsheet, you see that build up over time. And I think there's a psychological effect there. But, yeah, absolutely. So you you need to keep that contemporaneous log.
Jeremy Wells, EA, CPA:And for those of you who had been small business owners and you've, you know, worked in a business where you had to drive around, you should have heard that phrase from tracking your mileage, which you need to be doing with your real estate portfolio also. If you're driving to go check on your properties, if you're driving to go make repairs or mow the lawn or whatever you're doing for those properties, track the mileage and then also track the time. And I would make this two separate tabs inside that same spreadsheet file, right? You know, so that you keep it all in one place. But yeah, absolutely.
Jeremy Wells, EA, CPA:You need to track the the date, the amount of time, and you know, what you actually did during that time. And if you did multiple things, if you repaired a doorknob, spent a half hour doing that, and then you mowed the lawn for an hour, and then you did some other stuff, You know, track each one of those individually. Yeah. Because, you know, in your mind, this is all just working for your real estate portfolio. But there are rules.
Jeremy Wells, EA, CPA:There are certain activities that qualify, and then other activities that don't qualify. And if you're not a 100% clear on what qualifies and what doesn't, one, ask your tax adviser. But then in the meantime, just itemize all of that out and make it a lot easier on yourself during tax time. But yeah, definitely recommend tracking all that, and you need to be doing it contemporaneous. Don't wait until tax time.
Jeremy Wells, EA, CPA:Don't wait until, you know, six months or a year later, and then try to just remember, you know, all those little fifteen, thirty, sixty minute tasks that you completed at your rentals. Do that at least on a daily basis, if you're if you're doing that kind of work at your rentals.
Chris Picciurro, CPA:Well, I appreciate it. I would say, you know, as we wrap it up, material participation is required to to take in any type of activity, as you've said, from non from non or from passive to nonpassive.
Jeremy Wells, EA, CPA:Absolutely.
Chris Picciurro, CPA:Track things. If you tell your tax professional you had miraculously exactly 15,000 miles on your vehicle, they might not eye roll you out. But inside, they are, and and that's okay. We we just do it. You put out so much great content, not just professionals, for entrepreneurs.
Chris Picciurro, CPA:Can you let, as we wrap up, let everyone know how they can find you? And, obviously, we're gonna put it in the show notes.
Jeremy Wells, EA, CPA:Well, thank you very much. I appreciate that. So I I write a lot of my content is geared toward other tax professionals, but I do try to make it at least somewhat accessible to non tax pros if you're kinda on the nerdy side or you know, if you just wanna listen to where maybe your tax pros getting their ideas or information from. But right now it's, it's mostly two different things. One is a sub stack that I occasionally send out, I need to send out more.
Jeremy Wells, EA, CPA:But that's jaywells. Tax. And then I have the podcast which we have a new episode, they're usually around fifty to fifty five minutes, that's the minimum for one hour of CE for tax professionals continuing education. That comes out every other Wednesday. Each episode is is one specific tax topic that I do a little bit of a fifty minute deep dive on, go through the law, but also look at some case studies, try to make that make sense to to whoever's listening to it.
John Tripolsky:Awesome. Yeah. We'll definitely we'll drop in the show notes, as Chris mentioned as well too. And and Jeremy, my big takeaway from this, right, and I'll leave it kind of at that one is we started this off talking about education. Right?
John Tripolsky:And as a tax pro, I'm gonna make the assumption that you actually never stop educating your clients. Is is that a is that a correct assumption?
Jeremy Wells, EA, CPA:My one of the favorite parts of working in academia was not lecturing, not researching and writing, although I enjoyed all that work. It was the office hours. It was the one on one conversations with students when they would come. And a lot of times those conversations wouldn't be anything about the actual coursework we were doing. It would be about what are their career goals?
Jeremy Wells, EA, CPA:What are their life goals? What are they going through in life right now that made it to where they couldn't get their essay in on time? Right? Those sorts of things. And that's when I got to transition from being a professor to an actual counselor and in some cases coach.
Jeremy Wells, EA, CPA:And I've always tried to capture and keep a little bit of that in the accounting work that I do. And I've gotten to a point now to where I feel just confident enough to not only do that with clients, but also do that with other tax tax professionals who are trying to get their start in this profession as well. So yeah, absolutely. Definitely definitely education is still a key part of the the work that I'm trying to do. It's mostly client work, but trying to factor in a little bit more of that kind of work too.
John Tripolsky:Awesome. Well, it keeps you sharp. And and, Chris, good call having Jeremy on with us to talk about this topic. And, yeah, man, we'll, we'll have you back. So we'll we'll ping you at some point and harass you to come back on the show with us.
Jeremy Wells, EA, CPA:I appreciate it. I'll be looking forward to it.
John Tripolsky:Show notes, links in there. Click on them, follow them, and we'll see you back here again next week on the teaching tax law podcast. Have a great week, everybody.
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