KBKG Tax Insight: Overcoming Passive Losses from Self-Rental Property Using the Grouping Election (2024)

By Eddie Price & Amar Patel | Principals - Cost Segregation

When business owners acquire a building that they intend to use primarily to operate their business, they often set up a separate LLC to hold the building and land asset that is owned by individuals instead of the operating business entity. This is beneficial for asset protection and estate planning purposes; but, if the LLC holding company generates losses, a federal tax dilemma is created known as “the self-rental rule”. Business owners who perform a cost segregation study on the building in an effort to generate additional deductions in the current year may find that they are not able to use any of the losses generated from the real estate rental against their operating business income.

Under the self-rental rule, the rental losses are still considered to be passive losses deductible only to the extent of passive income, while rental income generated from self-rentals is treated as “active” income if the taxpayer materially participates, as defined in IRC §469(h), in the activities of the operating business entity. The IRS considers losses from rental real estate activities to be passive and passive losses cannot be deducted against non-passive income sources (e.g., income from the operating entity).

It’s important to understand you can overcome the self-rental rule by meeting certain criteria and making a grouping election under IRC §469(c)(7)(A).

KBKG Insight: If a grouping election is made that includes a building, a cost segregation study can generate significant depreciation deductions that can be used by other entities within the grouping. Under current rules, any building component reclassified in a cost segregation study is fully deductible in the year acquired and placed in service. The passive activity rules, however, can be an obstacle to taking full advantage of the bonus depreciation rules.

The Grouping Election

One way to convert activities that would otherwise be passive to non-passive is to group them collectively as a single activity. Regs. §1.469-4(c)(1) provides guidance for grouping activities using a facts and circ*mstances test to evaluate the appropriateness of the grouping. In order to be grouped under IRC §469, activities must constitute an appropriate economic unit for measuring gain or loss. The most significant factors to consider in this determination include:

1. Similarities and differences in type of trades or businesses;
2. The extent of common control;
3. The extent of common ownership;
4. Geographical location; and
5. Interdependencies between or among the activities

A rental activity cannot be grouped with a trade or business activity unless either the activity is insubstantial when compared to the other activity or has the same proportionate ownership interest in the rental activity. In the case of an owner-occupied building, these criteria are usually met.

KBKG Case Study: Sally is an orthopedic surgeon with $700K of taxable income from her S-Corp medical practice for the current tax year. She spends $6M to acquire a building for use in her medical practice. The building is held in a separate LLC owned 100% by Sally. Sally commissions a cost segregation study that identifies portions of the building that can be written off immediately.

The cost segregation study identifies $1.4M in additional current year deductions in the LLC while net income in the LLC before depreciation is only $140K. The excess $1.26M in deductions generated in year 1 by the cost segregation study will likely cause a passive loss in the LLC that holds the building. Without the grouping election the passive loss is suspended and carried forward for use in future years. With the grouping election, Sally’s taxable income is reduced to $0 and the remaining $560K ($1.26M – $700K) is carried forward for use in future years.

KBKG Insight: Taxpayers with depreciable interests in rental real estate that are greater than $1M and placed in service during the last 20 years may benefit from electing to group activities. Taxpayers should evaluate the application of an ‘appropriate economic unit’ based on relevant facts and circ*mstances to determine if their interests can be combined into a single activity.

Procedures:

The election is a statement that must be attached to the tax return and filed by the due date, including extensions, for the year in which the taxpayer wishes to make the election. It can be made by individuals, C Corps, S Corps, partnerships, trusts, and estates. Once made, the grouping must remain consistent from year to year unless:

1. It is determined that a grouping was clearly inappropriate;
2. A material change in facts and circ*mstances warrants a grouping change; or
3. The IRS finds that a group of activities does not represent an appropriate economic unit and a principal purpose of the grouping is to circumvent the underlying purposes of IRC §469.

Conclusion

Self-rental transactions can generate suspended passive losses when business owners acquire buildings for use primarily in operating their business. If these separate business activities can be grouped into one economic unit under IRC §469 then losses from the real estate holding company can be used to offset income from the taxpayer’s operating entity. Significant additional deductions within the real estate holding company can be generated by performing a cost segregation study of the building.