Thirty years ago, Congress passed the Tax Reform Act of 1986. Within the Act, the Passive Activity Loss (PAL) rules limited the ability of taxpayers to take income tax loss deductions from business or rental real estate activity unless the taxpayer “materially participates” by satisfying certain tests based on hours worked in the activity. Depending on the activity, the annual required hours are 750, 500, or as low as 100. If the government disputes the taxpayer’s loss deduction, then it is up to the taxpayer to prove material participation, which may be difficult and time consuming if reconstructed years later. The regulations state:
“The extent of an individual’s participation in an activity may be established by any reasonable means. Contemporaneous daily time reports, logs, or similar documents are not required if the extent of such participation may be established by other reasonable means.”
But the best method is keeping contemporaneous logs of work done.
There are many other PAL rules. Careful structuring of ownership and operations and in making tax elections may assist minimizing the PAL loss limitations, as well as avoiding the new 3.8% Net Investment Income Tax, which applies many of the same rules.