Material participation is at the heart of many powerful tax strategies. Whether you’re running a small business, flipping houses, managing a short-term rental, or launching a new company, your ability to deduct losses often depends on whether you put in enough hours to “materially participate” during the year.
In most cases, taxpayers must pass one of seven material participation tests (commonly working more than 100 hours and no one else working more); or more than 500 hours during the year. (We have a full list of all seven tests here: Counting and Grouping Materials Engagement Hours.)
If you meet one of these tests, you participate materially. If you don’t, the activity is passive and passive losses are often suspended.
A simple example makes this clear.
Let’s look at a simple example. Suppose Tom and Dick each start new businesses in 2025. They both generate a loss of $100,000.
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Tom participates materially → can probably deduct the loss.
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Dick does not materially participate → his loss is likely to be suspended under passive activity rules.
So far, nothing surprising. But within this area of law there is a question that many professionals get wrong: When Do you start counting hours for material participation?
Let’s discuss the incorrect answer and then share the correct answer from Treasury Regulation, which most professionals never cite.
The wrong answer: “You start counting when the business starts.”
This is the general opinion and it seems reasonable:
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For a rental property: counting begins when the property is placed in service.
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For a restaurant: when opening the doors.
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For a consulting company you bought: when you take over operations.
IRS auditors say this. Many CPAs say this. Even tax lawyers say this.
But the regulations do not say this.
And in many cases, this response causes taxpayers to incorrectly conclude that they cannot materially participate in the first year of operation, when in fact they can.
What the regulations really say
Treasures. Reg. §1.469-4(b)(1) defines what counts as an activity for material participation purposes. And it includes three categories of work:
1. Conduct of trade or business
This is the obvious one: the hours you work after the business is up and running.
This covers:
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Tenant communication in a rental activity.
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Hosting guests in a short-term rental
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Serving customers in a restaurant.
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Produce goods or services in an operating business.
Nothing controversial here.
2. Work done in anticipation from the start of the activity
This is the critical and widely misunderstood part. The regulation explicitly includes activities “carried out in anticipation of the commencement of a commercial or business activity.”
In simple English: Pre-launch work counts.
Hours dedicated to:
…all count toward material participation, as long as they occur in the same taxable year in which the business was started (and none of the “throwaway rules” I’ll talk about in a few paragraphs apply).
This is enormously important for taxpayers launching new businesses or purchasing real estate. (In many cases, it would not be possible to start a new business safely and intelligently without putting in at least 100 hours.)
3. Research and experimental activities under article 174.
If your business starts with:
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software development
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product research
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formulation work
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feasibility studies
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experimentation
…those hours also count towards material participation.
This can be very important for tech startups or any company where the “R&D phase” consumes most of the first year.
Does this apply to rental activities? Yeah.
A technical point for tax accountants who read this and have read the regulations. Many people assume that rentals are different because regulations define “rental activities” separately.
But Treasures. Reg. §1.469-4(b)(2) simply cross-references the definition of rental activity. It does not exclude rentals from the rule that allows:
If you are starting a short-term rental business and put in 200 hours in the spring:
…and then put the property into service that same year?
Those 200 hours count.
This can easily push a taxpayer over the 100-hour or even 500-hour thresholds.
Why this is so important in first-year loss situations
Many first-year businesses, including rental businesses, incur significant startup costs, depreciation, and operating losses.
Taxpayers, and sometimes even preparers, often assume:
“Well, I didn’t start trading until September and I only have 60 hours during those last four months of the year. I guess I can’t materially participate.”
But that assumption is almost always wrong.
If you spent a lot of time preparing the business at the beginning of the year, those hours usually count.
This is especially relevant for:
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Short-term rentals (property acquisition is labor-intensive)
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Real estate investments
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New professional practices
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Restaurants and hospitality businesses.
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Software development startups
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Any company with great pre-launch planning.
A practical example with a short-term rental
Let’s look at a very common example in which an error occurs in this part of the law. Let’s say Sarah decides in January to start a short-term rental business. She spends:
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120 hours researching markets
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80 hours touring properties
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40 hours negotiating financing
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60 hours of software configuration, decoration planning, cleaning staff onboarding
Close on a property in August and start renting it in September. Once rented, it spends another 60 hours on operations.
Sarah’s total hours for the year:
120 + 80 + 40 + 60 + 60 = 360 hours
Easily passes the 100-hour test and often the 500-hour test, depending on additional operational activity.
However, many trainers would mistakenly tell you that you only have about 60 hours of participation.
Some final guidelines
For all of this to work in practice, taxpayers must do two things:
1. Keep contemporaneous records
A simple check-in, even in Outlook, Google Calendar, or a notes app, works. But you need dates, times and descriptions. You want to track the hours of the owner and the hours of the owner’s spouse. You also want to track the hours spent by your suppliers.
2. Avoid “discard” categories
Reg. §1.469-5T(f) excludes:
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purely investment activities if they do not participate in daily operations
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hours not customarily performed by the owners if they are only performed to qualify as materially participating
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capital acquisition job for someone who No operate the business
These categories rarely apply to someone who will personally operate a short-term rental or small business. But they are important for passive investors.
The great takeaway
The regulations make it clear: material participation does not begin when the business begins. starts when you start working in the business, as long as it is in anticipation of the start of the activity.
For many taxpayers, this means they count more hours than they realize. And it means that first-year losses are more deductible than they thought, as long as they meet one of the material participation tests.
And for short-term rental operators in particular, the hours spent searching, analyzing, acquiring, furnishing and preparing a property typically make up the majority of total hours involved.
That’s good news, as long as you keep good records.
Other Resources You May Find Helpful
A dozen ways to deduct passive losses
Short-Term Rental Depreciation Deduction Calculator
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