Rental Property Grouping Elections: Passive Loss Rules for Real Estate Investors
How rental properties are grouped for passive activity purposes can materially change whether losses are deductible, whether a taxpayer materially participates, and when suspended passive losses are released after a property sale.
The rules are often misunderstood because there are two different concepts that taxpayers commonly call a grouping election.
Regulation Section 1.469 4 contains general activity grouping rules. Regulation Section 1.469 9 contains a separate election allowing a qualifying real estate professional to treat all interests in rental real estate as one rental real estate activity.
Key Tax Takeaways
- General Section 469 grouping and the real estate professional rental aggregation election are different rules.
- General grouping requires activities to form an appropriate economic unit.
- Relevant factors include similarity, common control, common ownership, location, and interdependence.
- A rental activity generally cannot be grouped with a trade or business unless a regulatory exception applies.
- A qualifying real estate professional can elect to treat all interests in rental real estate as a single rental real estate activity.
- The real estate professional election can make material participation easier to establish across several properties.
- The same election can make it harder to obtain a complete disposition release when only one property is sold.
- The real estate professional election generally remains binding for future years in which the taxpayer qualifies.
- Being less advantageous in a later year is not by itself sufficient reason to revoke the election.
- Late election relief can be available under Revenue Procedure 2011 34 when the requirements are satisfied.
Why Does Grouping Matter?
Passive activity rules are applied by activity.
If several properties are separate activities, the taxpayer can be required to establish material participation separately for each activity.
If qualifying activities are treated as one activity, the taxpayer's participation generally is evaluated across the combined activity.
Grouping also matters when a property is sold. A sale of one property can be a complete disposition when it is a separate activity, but only a partial disposition when it is part of a larger grouped activity.
What Is General Grouping Under Regulation Section 1.469 4?
One or more trade or business or rental activities can generally be treated as a single activity when they form an appropriate economic unit for measuring gain or loss under Section 469.
The factors given the greatest weight include:
- Similarities and differences in the types of businesses
- Common control
- Common ownership
- Geographical location
- Interdependencies among the activities
Not every factor has to point in the same direction. The complete facts determine whether the grouping is reasonable.
Can Rental Property Be Grouped With an Operating Business?
Generally not, unless one of the regulatory exceptions applies.
A rental activity and trade or business activity must first form an appropriate economic unit. In addition, the rental or business generally must be insubstantial relative to the other, or each owner of the operating business must hold the same proportionate ownership interest in the rental activity for the applicable property rented to the business.
What Is the Real Estate Professional Aggregation Election?
A taxpayer who qualifies under Section 469(c)(7) can elect to treat all interests in rental real estate as a single rental real estate activity.
This can be particularly valuable when the taxpayer has several properties and does not have sufficient participation in each property independently.
Example: Four Rental Properties
Assume a qualifying real estate professional owns four rental properties and spends 180 hours on each property during the year.
If the properties are treated separately, the taxpayer must establish material participation separately for each activity.
If a valid election treats all rental real estate interests as one activity, the taxpayer has 720 hours of participation in the combined activity. Whether the combined activity satisfies a material participation test must then be determined under the applicable regulations.
Does the Election Automatically Make Rental Losses Nonpassive?
No.
The taxpayer first must qualify as a real estate professional. The taxpayer then must materially participate in the combined rental real estate activity.
The election changes the unit in which material participation is measured. It does not replace the material participation requirement.
How Is the Election Made?
A qualifying taxpayer generally makes the election by attaching a statement to the original federal income tax return for the taxable year.
The statement declares that the taxpayer is a qualifying taxpayer and elects under Section 469(c)(7)(A) to treat all interests in rental real estate as one activity.
Is the Election Permanent?
The election is generally binding for the year it is made and future years in which the taxpayer is a qualifying taxpayer.
A taxpayer can revoke it when a material change in facts and circumstances occurs and the regulatory procedure is followed.
A Later Tax Disadvantage Is Not Enough
The regulations specifically state that the election becoming less advantageous in a particular year is not by itself a material change that permits revocation.
Why Can Grouping Create a Problem When One Property Is Sold?
Section 469(g) generally releases suspended passive losses when the taxpayer disposes of the entire interest in a passive activity to an unrelated person in a fully taxable transaction.
If several rental properties are treated as one activity, selling one building generally does not mean the taxpayer has disposed of the entire combined activity.
Example: Selling One Property From a Group
Assume three rental properties are one combined activity and the taxpayer has $150,000 of suspended passive losses associated with that activity.
The taxpayer sells one property but retains the other two.
The sale generally is not a disposition of the taxpayer's entire interest in the combined activity merely because one building was sold. The suspended losses therefore do not automatically receive the full Section 469(g) release.
Can Prior Suspended Losses Benefit From Grouping?
Grouping can also help in later years.
If a previously passive rental activity becomes part of a combined activity in which the taxpayer materially participates, the former passive activity rules can allow prior suspended losses to offset current income from the combined activity to the extent permitted under Section 469(f).
What About Rental Real Estate Held Through Partnerships?
Rental real estate held through partnerships and S corporations requires another layer of analysis.
The entity first determines its activity groupings. A partner or shareholder generally cannot separate activities that the entity itself has grouped.
A qualifying taxpayer can nevertheless apply the special rental real estate election to qualifying interests held through pass through entities, subject to the detailed rules in Regulation Section 1.469 9.
What About Limited Partnership Interests?
Limited partnership interests can restrict which material participation tests are available.
Regulation Section 1.469 9 contains special rules when a qualifying taxpayer combines rental real estate that includes limited partnership interests. A de minimis exception can apply when the taxpayer's limited partnership rental income is less than 10 percent of total gross rental income from all rental real estate interests.
Does the Election Include Short Term Rentals?
Not necessarily.
The special Regulation Section 1.469 9 election applies to interests in rental real estate. A short term lodging activity that meets an exception from the Section 469 rental activity definition can instead be a trade or business activity.
General grouping rules can then require a different analysis.
What if the Election Was Not Attached to the Original Return?
Revenue Procedure 2011 34 provides late election relief for certain taxpayers who failed to timely make the Regulation Section 1.469 9 election.
The taxpayer must satisfy the revenue procedure's eligibility and consistency requirements. Late relief should not be assumed merely because the taxpayer qualified as a real estate professional.
General Grouping Disclosure Requirements
Revenue Procedure 2010 13 establishes disclosure requirements for certain new groupings, additions to groupings, and regroupings.
Failure to make required disclosures can cause activities to be treated separately unless applicable relief requirements are satisfied.
What Should Be Reviewed Before Making a Grouping Election?
- Number and type of rental properties
- Participation hours by property
- Use of property managers
- Existing suspended passive losses
- Expected property sales
- Partnership and S corporation interests
- Limited partnership interests
- Short term rental activities
- Real estate professional qualification
- Prior grouping statements
- Prior returns and Form 8582 history
Frequently Asked Questions
Is grouping the same as qualifying as a real estate professional?
No. Qualification and grouping are separate tax determinations.
Does grouping make all losses deductible?
No. Material participation and other loss limitations still apply.
Can I group rental property with my operating business?
Only when the requirements of Regulation Section 1.469 4 are satisfied.
Can I revoke the real estate professional aggregation election?
Generally only after a material change in facts and circumstances and by following the regulatory procedure.
Can I make the election late?
Revenue Procedure 2011 34 provides late relief for certain qualifying taxpayers.
Review the Grouping Before It Becomes Permanent
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