When Grouping Rental Activities Is Beneficial for Tax Purposes

1. Meeting Material Participation for Real Estate Professionals:

Grouping is especially valuable for real estate professionals subject to the passive activity loss (PAL) rules. By default, each rental property is treated as a separate activity, and material participation must be established for each property individually. This can be difficult for taxpayers with multiple properties. By electing to group all rental real estate interests as a single activity, the taxpayer can aggregate hours across all properties, making it easier to meet the 500-hour material participation test and convert passive losses into nonpassive losses that can offset other income.

2. Maximizing Passive Loss Deductions:

Grouping can also be useful when a taxpayer has both passive income and passive losses among different rental properties. By grouping, losses from one property can offset income from another within the same aggregated activity, maximizing the use of passive loss deductions.

When Grouping Is Not Necessary or May Be Disadvantageous

1. Profitable Properties and Passive Loss Offsets:

If rental properties are profitable, grouping may not be beneficial. Grouping could cause the income to be treated as nonpassive, which means passive losses from other activities cannot be used to offset the rental income. In such cases, it may be preferable for the rental activities to remain passive so that passive losses from other sources can offset the passive rental income.

2. Different Ownership Structures:

Grouping is only allowed when the ownership interests in the activities are the same. If properties have different ownership structures (e.g., different partners or ownership percentages), grouping is not permitted for those activities.

3. Limiting Future Planning Flexibility:

Once activities are grouped, the grouping generally cannot be changed unless there is a material change in facts and circumstances. This can limit future planning flexibility. For example, if grouped activities are later disposed of in part, suspended passive losses may not be fully deductible until there is a complete disposition of the entire grouped activity, potentially trapping losses for years.

4. Disposition of Properties:

If properties are grouped and one is sold, only a partial disposition has occurred, and suspended passive losses related to the sold property may not be deductible until the entire grouped activity is disposed of. If properties are kept as separate activities, the sale of one property allows for the deduction of its suspended passive losses immediately.

5. Real Estate Professionals and Grouping with Other Activities:

For real estate professionals, grouping rental real estate activities with other activities is not permitted for purposes of determining material participation. Each rental real estate activity must be tested separately, which can limit the ability to use grouping to achieve nonpassive treatment in some cases.

Summary

Grouping rental activities is a powerful tool for real estate professionals to meet material participation requirements and maximize passive loss deductions, but it is not always necessary or beneficial. It may be disadvantageous when properties are profitable, have different ownership structures, or when grouping could limit future planning flexibility or trap suspended losses. Each situation should be evaluated based on the taxpayer’s specific facts and objectives.

For more detailed guidance, consult the relevant IRS publications and authoritative tax resources or click Contact to speak with an experience tax advisor.