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IOWA CAPITAL GAINS DEDUCTION: WHAT IS MATERIAL PARTICIPATION?

March 05, 2004

Iowa allows some business owners to exclude capital gains on the sale of a business, or of business real estate. Taxpayers wishing to qualify for this "capital gain deduction" must clear two hurdles:

-10-Year holding period: the property has to be "held" for 10 years or more prior to the sale.

-10-year material participation: the taxpayer has to have "materially participated" in the business for 10 years.

The "material participation" test for the capital gain deduction piggybacks on the definition of the term under the federal "passive loss" rules. The tax law disallows net losses from "passive" activities; such losses carry forward until they are offset against passive income. These rules are very complex, but the basics are easy to grasp.

You "materially participate" in an activity if you meet one of several tests:

- You participate in an activity more than 500 hours in a year.

- You participate in multiple activities over 100 hours per year, and the time in such activities added together exceeds 500 hours.

- You participate more than 100 hours in a year in an activity, and more than anyone else.

- Your participation in the activity is all the participation there is.

- You participate more than 100 hours, and your participation under the circumstances is "regular, continuous and substantial." As a practical matter, this mostly covers the first or last years of participation when the participation began too late in the year to meet the 500-hour test.

RENTAL ACTIVITY USUALLY DOESN'T COUNT.

Rental activity doesn't count for material participation unless you are a "real estate professional" who spends more than half of your working time and more than 750 hours per year in your rental real estate businesses.

IS THERE SUCH A THING AS ACTIVE PASSIVITY?

The tax law does give taxpayers a few breaks in reaching these requirements:

- Your spouse's participation counts as your participation.

- You are considered to participate in an activity for a year if you have materially participated for five of the past ten years.

- If you participate in a "personal service" activity for three years, you are considered a material participant for life.

NOT ALL PARTICIPATION COUNTS.

The tax law will ignore participation if it's just "make work" to get hours in. For example, time spent by a factory owner's spouse answering phones may not qualify.

HOW WILL THEY KNOW HOW MUCH TIME I'VE WORKED?

That's a darn good question. A diary or time reports would be ideal, but normal people (as opposed to accountants and attorneys) don't keep such things. The tax law doesn't require a diary or log of your participation. In cases and IRS exams, phone logs, overnight mail receipts, signed documents, and narrative descriptions of the business activity have been used to help document the participation. A narrative description will help if the other evidence supports it. Commuting time doesn't count. If your participation is borderline, you might want to keep a log and build your paper trail.

Prior coverage of the Iowa capital gain deduction:

IOWA'S REALLY LONG-TERM CAPITAL GAIN DEDUCTION

The Iowa regulations on the capital gain deduction, including material participation rules, are here.

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