You can overcome the self-rental rule by meeting certain criteria and making a grouping election under IRC §469(c)(7)(A):
Notwithstanding clause (ii), a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.
With grouping you can potentially convert passive activities into non-passive ones, allowing you to offset your business income with rental losses.
IRC §469 allows taxpayers to group certain activities into a single economic unit if they meet specific criteria. This grouping can convert passive activities into non-passive ones, thereby overcoming the self-rental rule. According to Regs. §1.469-4(c)(1), activities must constitute an appropriate economic unit for measuring gain or loss. The factors to consider include:
Activities should be similar in nature. For example, owning a building and operating a business within that building can be seen as complementary activities.
The same person or group should control both activities. For instance, if you own both the rental property and the business, this criterion is met.
The ownership interests in both activities should be proportionate. If you own 100% of both the rental property and the business, this criterion is satisfied.
Activities located in the same geographical area are more likely to be considered a single economic unit.
Activities should be interdependent. For example, the business should rely on the rental property for its operations.
A rental activity cannot be grouped with a trade or business activity unless either the rental activity is insubstantial compared to the business activity or both activities have the same proportionate ownership interest. In the case of an owner-occupied building, these criteria are usually met.
Cost Segregation Study A cost segregation study can be particularly beneficial when grouping activities. This study reclassifies building components into shorter depreciation periods, generating significant depreciation deductions. Under current rules, any building component reclassified in a cost segregation study is fully deductible in the year acquired and placed in service. However, the passive activity rules can limit the ability to fully utilize these deductions.
Applicability and Benefits Taxpayers with depreciable interests in rental real estate greater than $1 million and placed in service during the last 20 years may benefit from electing to group activities. Evaluating the application of an ‘appropriate economic unit’ based on relevant facts and circumstances can determine if interests can be combined into a single activity.
Procedures for Making the Grouping Election To make the election, attach a statement to your tax return and file it by the due date, including extensions, for the year in which you wish to make the election. The election can be made by individuals, C Corps, S Corps, partnerships, trusts, and estates. Once made, the grouping must remain consistent unless:
Self-rental transactions can generate suspended passive losses when business owners acquire buildings primarily for use in their business operations. By grouping these activities into one economic unit under IRC §469, you can use losses from the real estate holding company to offset income from the operating entity. Additionally, performing a cost segregation study can generate significant additional deductions within the real estate holding company.
Case Study Alex, a surgeon, earns $800K in taxable income from his S-Corp medical practice this year. He spends $6M to acquire a building for his practice, held in a separate LLC he owns entirely. Alex commissions a cost segregation study to identify portions of the building that can be written off immediately.
The study identifies $1.4M in additional current year deductions in the LLC, while the LLC’s net income before depreciation is only $140K. This creates an excess of $1.26M in deductions ().
Without grouping election:
With grouping election:
By leveraging a cost segregation study and making a grouping election, Alex can significantly reduce his taxable income and carry forward excess deductions, optimizing his tax strategy for both the current and future years.