Investing in real estate is a popular venture for business owners looking to diversify their portfolios and benefit from the tax losses generated by rental properties through depreciation. However, navigating the tax landscape for rental properties is not always straightforward. One significant hurdle to claiming these losses is that rental real estate is considered a passive activity. This means losses can only be deducted against other passive income, which can result in losses being carried forward for years, potentially until the property is sold. Fortunately, there are ways to overcome these limitations and maximize the tax advantages of real estate investments.
Real Estate Professional Status
The main way to prevent limitations on rental losses is to qualify as a real estate professional. However, the rules for qualifying are extensive, and not all real estate investors can meet the criteria to achieve this status.
To qualify, 50% of an investor’s time spent in a trade or business must be in a real property trade or business. The investor must also perform a minimum of 750 hours of service in real property trade or businesses and materially participate in each rental activity—unless the investor makes an election to group all properties together.
To claim material participation in each rental activity, the taxpayer must meet at least one of these seven benchmarks:
- Work more than 500 hours in the activity
- Do substantially all of the work associated with the activity.
- Work more than 100 hours in the activity, and more than any other individual.
- Participate in several significant activities, each involving more than 100 hours, with the total time across these activities exceeding 500 hours.
- Have materially participated in the activity during any five of the prior 10 years.
- Have materially participated in a personal service activity—such as those in health, law, engineering, or accounting—for any of the three previous tax years.
- Participate in the activity on a regular, continuous, and substantial basis throughout the year.
Investors who meet these requirements for real estate professional status are not subject to passive loss limitations on their rental activities, allowing them to fully deduct their rental losses against other income.
Grouping Elections Explained
For investors who plan to acquire a building primarily for their business operations, they will be subject to self-rental rules. These rules state that the rental losses are still considered passive and, therefore, are subject to the passive loss limitations on their deductibility. However, a grouping election under IRS Regulation Sec. 1.469-4 offers a potential solution.
This election allows the rental property to be grouped with the operating company as a single activity for the purposes of the passive activity rules. By making the grouping election, the self-rental activity would then be considered active income or loss, enabling investors to offset rental losses against active business income. Rental activities are eligible for the grouping election if they constitute an appropriate economic unit, and either the rental activity and the trade or business are insubstantial in relation to one another, or the owners of the trade or business have the same proportional ownership in the rental activity. This election is particularly beneficial for taxpayers who have no other passive income that would allow them to utilize passive losses.
If the taxpayer qualifies to make the grouping election, it must be made on the first tax return where both activities are reported. Once the election is made, the rental losses can be used to offset the active income of the operating company. This reclassification could also help maximize the benefit of the qualified business income (QBI) deduction, a 20% adjustment to taxable income calculated on passthrough income, by including rental property income that may have been excluded otherwise. Once established, the grouping must be used until there is a material change in facts and circumstances that would render the current grouping no longer appropriate.
Tax Savings Through Grouping
A major benefit of this grouping election is that it allows taxpayers to use a cost segregation study to accelerate depreciation in the building’s first year, reducing their taxable income. Cost segregation studies break down commercial and residential properties into categories with shorter depreciation periods—15, 7, or 5 years. Assets with shorter depreciation periods than the standard 39 years for commercial properties or 27.5 for residential properties are eligible for bonus depreciation. For tax year 2024, bonus depreciation allows a 60% first-year deduction on eligible assets. This deduction usually generates significant losses. However, if the activities are not appropriately grouped, the increase in depreciation could be considered a passive loss, which is disallowed and carried forward.
Final Thoughts
It is important to understand the requirements for qualifying for these tax savings strategies. There are many factors to consider before deciding if pursuing real estate professional status or a grouping election makes sense for your specific tax situation. To ensure the most favorable outcome, it is important to consult with a qualified tax advisor before making the election.
Sarah Fordyce is a tax manager specializing in real estate for 1RDG, the financial center, which provides businesses with a full range of management, compliance, and advisory services. For more information, please visit 1RDG.com.