According to the IRS, a trade or business is considered a passive activity unless the taxpayer materially participates.
You can claim to have materially participated in the operation of a trade or business activity by meeting one of seven following tests:
1. You work 500 hours or more in the activity during the year.
2. You do all or nearly all of the work in the activity.
3. You work more than 100 hours in the activity during the year, and no one else works more than you do.
4. The activity is a significant participation activity, and the sum of the SPAs in which you work 100 to 500 hours exceeds 500 hours for the year.
5. You participated materially in the activity in any five of the previous 10 years.
6. The activity is a personal service activity and you participated materially in that activity in any three prior years.
7. Based on all of the facts and circumstances, you participate in the activity on a regular, continuous and substantial basis during that year. Note that this test applies only if you work at least 100 hours in the activity, no one else works more hours than you in the activity and no one else gets compensation for managing the activity.
In some cases, you may be able to group related businesses as a "single activity" to meet one of the above tests. Participation by your spouse during the tax year in a business you own can also be counted as your participation in the activity -- even if your spouse does not own an interest in the activity, and regardless of whether you file a joint income tax return. It is important to note that the IRS may become suspicious of your claim that you or your spouse participated materially in the business if, for example, you live far from the business, you were not compensated for your work or you have a full-time job or many other businesses and investments to manage.When it comes to rental activities, it can be more difficult for one to claim material participation. According to the IRS, the long-term leasing or rental of real estate is considered a passive activity even if you participated materially in the activity. This is true unless you participated materially in a rental activity as a real estate professional. To qualify as a real estate professional, more than half of the work you perform in trades or businesses during the taxable year must be in real property activity in which you participate materially. Additionally, you must work more than 750 hours a year in these trades/businesses. Keep in mind, however, that you may be allowed to deduct up to $25,000 of rental property passive income losses as long as you can demonstrate that you actively participate in the property. Active participation means you must own at least a 10% stake, and you must be making management decisions (such as approving tenants, setting rental terms and authorizing repairs). Note that this tax deduction phases out at modified adjusted gross incomes that are between $100,000 and $150,000.