Grouping and the Passive Activity Rules
If you own investment properties, or a piece commercial real estate such as an office building, the passive-activity rules have significant tax implications. These rules prevent you from using expenses from passive activities against your other sources of income. While the rules were designed to prevent abusive tax shelters, they can also become an obstacle that prevents small-business owners from taking full advantage of legitimate business deductions.
For example, a doctor may conduct his business under one entity, but use a real estate holding entity for his office building. Unless his CPA or tax preparer files a grouping disclosure on his tax return, any deductions from his real estate will be considered passive losses. These passive losses can only be used against passive income, so he would not be able to use these losses against the income he makes from seeing patients.
As a potential solution to this problem, taxpayers are allowed to group their activities under certain conditions, such as the self-rental scenario described above. Grouping can allow business owners to take full advantage of depreciation and other real estate deductions against their primary sources of income. This article will provide a summary of the passive-activity rules and grouping procedures as outlined in IRS Publication 925.
The Self-Rental Trap
If you collect rent from commercial or residential rental properties, your rental income is almost always passive. Many business owners self-rent—i.e., they pay rent to their real estate holding entity using income from their operating entity. If you self-rent, passive activity rules can become a major issue. By default, your real estate losses will be trapped in the real estate entity and cannot be used against your operating income. The losses will remain trapped there until you completely dispose of your interest in the activity or until you have enough rental income to offset the loss.
To avoid this trap, you need to make a grouping election in the year the building is placed in service. The grouping election will allow you to use your losses from the real estate entity against your operations income. You can only group your activities if they constitute an appropriate economic unit.
Publication 925 notes five factors that you should consider when deciding whether you activities are an appropriate economic unit:
Similarities and Differences in the types of business
The extent of common control
The extent of common ownership
The geographic location
The interdependence of the activities
The doctor from the previous example may be able to reasonably argue that his rental activity and operations activity are an appropriate economic unit. He may be able to group his activities and avoid the self-rental trap.
To group your activities, you must attach a grouping disclosure to your tax return. The disclosure must list the names of the activities to be grouped, the addresses of the activities, and their employer identification numbers. Once a grouping election has been made, the grouping cannot be changed unless the original grouping was clearly wrong or unless there is a major change that makes the current grouping inappropriate.
Once you have grouped your activities, you are allowed to use losses from one activity against the income from the other activities in the group.
Grouping and Cost Segregation Deduction
The Tax Cuts and Jobs Act allows for a large portion of a building’s depreciation to be accelerated in the first year of ownership. A cost segregation study helps building owners maximize their deductions under the current laws. However, unless a taxpayer’s activities are appropriately grouped, the increase in depreciation could be considered a passive loss. Appropriate grouping can allow taxpayers to use depreciation deductions against their active sources of income. If grouping is not used, business owners could miss out on the benefits of the new tax laws.
Cost segregation and grouping are just one part of the approach to minimizing tax liability. Our goal is to help small business owners maximize their deductions and allow them to reduce their tax liability in the early years of business ownership. Our clients often use their tax savings to grow their business, hire new employees, or buy new equipment.
You may be eligible for additional deductions under the current tax law. We can run a no-cost projection of the tax savings available to you through cost segregation. Contact us for more information, or use our online form to request a cost segregation estimate for your property.
For more information please contact our Director of Cost Segregation at clayton@lumpkinagency.com.
The information provided in this blog is intended for general information only, and is not meant to constitute tax advice.