The Material Participation Rule Most Professionals Don’t Know

If you practice tax long enough, you start to notice a pattern. The provisions that matter most are often the ones that get the least attention. The passive activity loss rules are a perfect example. Every CPA and tax advisor learns them. Most remember the 500-hour test. Some remember the 100-hour test. Very few remember the other five tests. And almost nobody remembers hearing about the one that might matter most for their high-income clients looking for tax-advantaged opportunities.

Let me walk you through the history, the law, and the test that could change how you view your clients’ tax-advantaged opportunities, especially as it relates to passive/active losses and depreciation.

How We Got Here

To understand why the passive activity rules exist, you have to go back to the late 1970s and early 1980s. The top marginal income tax rate was 70%. And a cottage industry had sprung up around a simple idea: use paper losses from businesses you didn’t actually run to wipe out the tax on income from businesses you did run.

The mechanics were straightforward. A surgeon earning $500,000 a year would invest in a limited partnership that owned oil wells, or cattle feeding operations, or leveraged real estate. These partnerships generated large deductions, often from accelerated depreciation and prepaid expenses, that far exceeded any economic loss the investor actually bore. The surgeon would take those paper losses on her personal return, offset her surgical income, and dramatically reduce her tax bill. She never set foot on a drilling rig or a feedlot. She just wrote a check and collected a tax benefit.

By 1983, the IRS estimated that roughly 325,000 tax returns involving potentially abusive shelters were under audit, with an estimated annual revenue loss of $3.5 billion. Congress had seen enough.

The response was the Tax Reform Act of 1986, which created the passive activity loss rules under IRC §469. The core principle was simple and blunt: if you don’t materially participate in an activity, the losses from that activity can only offset income from other passive activities. You can’t use them against your wages, your business income, anything else you actively earn, or even your portfolio income (dividends, interest, etc.).

Section 469 effectively divides a taxpayer’s income into three buckets. First, active (or non-passive) income: wages, salaries, and income from businesses where the taxpayer materially participates. Second, passive income: income from activities where the taxpayer does not materially participate. Third, portfolio income: interest, dividends, and capital gains.

That third bucket surprises a lot of practitioners. Portfolio income is not passive income, even though the taxpayer is entirely passive in generating it. A client with $200,000 in dividend income does not have $200,000 of passive income available to absorb passive losses. That dividend income sits in its own bucket, walled off from passive activity deductions. See §469(e)(1) and Temp. Reg. §1.469-2T(c)(3)(i).

The Seven Tests Nobody Memorized

The vast majority of people do not have much passive income. The higher the net worth of a taxpayer, the more likely they have some sort of passive income, usually through partnership interests in various types of investments. By the time you get to the family office level, the bulk of a taxpayer’s income may be passive. But that is not most taxpayers. For most of your clients, passive losses sit unused year after year unless they can be reclassified as non-passive through material participation.

So how do you establish material participation? Under Temporary Regulation §1.469-5T(a), there are seven independent tests. A taxpayer needs to satisfy only one of them. They are:

Test 1 (§1.469-5T(a)(1)): The taxpayer participates in the activity for more than 500 hours during the year. This is the one everyone knows.

Test 2 (§1.469-5T(a)(2)): The taxpayer’s participation constitutes substantially all of the participation in the activity of all individuals, including non-owners, for that year.

Test 3 (§1.469-5T(a)(3)): The taxpayer participates for more than 100 hours during the year, and the taxpayer’s participation is not less than the participation of any other individual in the activity for that year.

Test 4 (§1.469-5T(a)(4)): The activity is a “significant participation activity” (meaning the taxpayer has more than 100 hours in it), and the taxpayer’s aggregate participation across all significant participation activities exceeds 500 hours for the year.

Test 5 (§1.469-5T(a)(5)): The taxpayer materially participated in the activity for any five of the ten immediately preceding taxable years, whether or not consecutive.

Test 6 (§1.469-5T(a)(6)): The activity is a “personal service activity” (health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any trade or business in which capital is not a material income-producing factor), and the taxpayer materially participated for any three preceding years.

Test 7 (§1.469-5T(a)(7)): Based on all the facts and circumstances, the taxpayer participates on a regular, continuous, and substantial basis during the year.

Most practitioners gravitate to Test 1 (the 500-hour test) and sometimes Test 3 (the 100-hour test). But the test I want to focus on is Test 2.

The “Substantially All” Test

Here is what §1.469-5T(a)(2) actually says: “The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year.”

Read that carefully. There is no minimum hour requirement. None. If the taxpayer is the person doing substantially all of the work in the activity, and no one else is performing meaningful work, the taxpayer materially participates. Period.

This makes intuitive sense. Think about a small business owner who runs a seasonal operation that requires 60 or 80 hours of work per year. She does all of it herself. She doesn’t have employees. She doesn’t hire a manager. Under Test 1, she fails because she’s below 500 hours. Under Test 3, she might fail too if she’s below 100 hours. But under Test 2, she passes, because she did substantially all of the work.

A few important caveats. The IRS Passive Activity Loss Audit Technique Guide flags two common challenges to Test 2 claims. First, if the taxpayer hires contractors, property managers, or other service providers who perform significant work in the activity, those hours dilute the taxpayer’s claim to “substantially all.” Second, work that qualifies as mere “investor” activity under §1.469-5T(f)(2)(ii), such as reviewing financial statements, monitoring operations in a non-managerial capacity, or analyzing reports for personal use, does not count as participation. The taxpayer needs to be doing real operational work, and needs to be able to prove it.

What Windham Tells Us

The Tax Court’s decision in Windham v. Commissioner, T.C. Memo 2017-68, illustrates how Test 2 works in practice.

Patricia Windham was a financial advisor with Wells Fargo who had been in the brokerage business for over 30 years. She also owned and personally managed 11 rental properties (plus a 50% interest in a vacant lot). She worked at her brokerage from roughly 12:30 p.m. until the markets closed, and spent her mornings, weekends, and holidays on real estate: finding tenants, collecting rent, coordinating repairs, handling insurance, managing utilities, and overseeing every aspect of her properties herself.

Because Windham had not filed a §1.469-9(g) aggregation election, the Tax Court had to analyze material participation for each property separately. The court identified three of the seven tests as applicable: Test 2 (the “substantially all” test), Test 3 (more than 100 hours, not less than any other individual), and Test 7 (facts and circumstances). The court found that for 11 of her 12 properties, Windham met at least one of these tests.

The key principle: Windham did the work herself. She didn’t delegate to a property manager. She didn’t hire an onsite superintendent. For each property, her participation constituted substantially all of the participation in that activity. The court accepted that even where her hours on a given property were relatively modest.

Now, an important note: Windham is fundamentally a real estate professional case under §469(c)(7). Rental activities are treated as per se passive under §469(c)(2), so Windham first had to qualify as a real estate professional before the material participation analysis even mattered. But the material participation tests under §1.469-5T apply broadly to all activities subject to §469, not just real estate. The (a)(2) reasoning is portable. The rental real estate framework is not.

What This Means for Solar Tax Equity

Here is where it gets practical for high-net-worth clients who are looking for tax-advantaged opportunities, such as direct renewable energy ownership.

In a direct investment solar tax equity structure, the investor owns the solar project outright. This is not a partnership flip with a developer. The investor holds title to the panels, the equipment, and the contractual rights under the power purchase agreement. They are the owner and the operator.

If that investor is the person managing the project, and I mean actually doing the work: monitoring energy production, managing the relationship with the host building, overseeing maintenance and repairs, handling billing and collections, coordinating with the utility, and no one else is performing substantial work in that activity, the investor may satisfy the “substantially all” test for material participation under §1.469-5T(a)(2).

And here is the reality that makes this test particularly well-suited to solar: after watching numerous solar asset owners manage the systems they own, the truth is that there just isn’t that much operational work to do in a typical solar project. The system produces energy, the monitoring software tracks it, and the owner handles the occasional maintenance call, the billing, and the host relationship. It is not a 500-hour-per-year business. But that is exactly the point. When the total work in the activity is modest and the owner is the one doing all of it, the “substantially all” test works very well.

If the investor materially participates, and the activity is properly classified as a trade or business (not a rental activity), the tax benefits flow through as non-passive. The depreciation deductions can offset active income. The Investment Tax Credit can be applied against the tax attributable to active income. For a high-income professional, this is the difference between a tax benefit that works immediately and one that sits suspended in the passive bucket indefinitely.

Two threshold issues that any CPA evaluating this structure needs to understand:

First, the rental activity question. Under §469(c)(2), rental activities are per se passive regardless of material participation. Solar projects with power purchase agreements can look like rental activities if the customer’s use period exceeds certain thresholds. The six exceptions in Temp. Reg. §1.469-1T(e)(3)(ii) must be carefully analyzed, and the structure of the PPA matters enormously. If the activity is classified as a rental, the material participation strategy fails at the threshold. This is not a question a CPA should resolve alone; it requires careful legal analysis of the specific deal structure.

Second, the passive activity credit limitation. Even apart from the loss rules, §469(d)(2) separately limits passive activity credits. The Tax Court’s recent decision in Strieby v. Commissioner, T.C. Memo. 2025-28, confirmed that §48 Investment Tax Credits from a solar partnership are subject to the §469 passive activity credit limitation when the taxpayer does not materially participate. That case involved egregious facts (the promoter was sentenced to nine years in prison), but the court’s statutory analysis is clear: solar ITCs do not get a free pass around §469.

Practical Takeaways

The “substantially all” test under §1.469-5T(a)(2) is one of the most underutilized provisions in the passive activity regulations. It doesn’t get taught in CPE courses. It doesn’t show up in the standard §469 flowcharts. But for the right client in the right structure, it can be decisive.

For CPAs evaluating solar tax equity for their clients, the structure of the investment matters. Direct ownership structures can enable material participation in ways that fund models and partnership structures cannot. In a limited partnership, the investor is generally restricted to only three of the seven material participation tests (Tests 1, 5, and 6 under §1.469-5T(e)(2)), none of which is the “substantially all” test. LLC members may have broader access under Garnett v. Commissioner, 132 T.C. 368 (2009), but the analysis is fact-specific.

And one final point: the passive activity rules are complex and fact-specific. This article provides a framework, not a conclusion for any particular taxpayer’s situation. The rental activity classification, the at-risk rules under §465, and the excess business loss limitation under §461(l) are all separate gating issues that must be addressed before any of this analysis applies.

If any of this raises questions about a client’s situation, or if you’d like help performing the material participation analysis for a specific solar investment structure, we’re happy to talk it through. This is what we do every day.

This article is for informational purposes only and does not constitute legal or tax advice. The passive activity rules are complex and highly fact-specific. Consult a qualified tax professional before taking any position on material participation.