What is the True Downside of Grouping All of Your Rental Activities as a Real Estate Professional?

If you’re looking to qualify as a real estate professional and use the losses from your long-term rental properties to offset your W-2 or active business income, you’ll need to materially participate in your rental activities. 

The problem is meeting one of the seven material participation tests for each individual property is often not feasible, and you’ll make the grouping election found under Sec. 1.469-9(g) to treat all your rental activities as one. When you do this, you can meet one of the seven tests on your entire portfolio, rather than each individual property. 

However, making this grouping election may come with some negative consequences if you have previously suspended losses and sell one of your properties.

The question is what are those consequences, and is the downside of the election worth not making the election?

What are the Downsides of the Grouping Election and Why Does it Matter?

To understand the downsides of making the grouping election, we must first understand what happens if you don’t make this election. 

Assuming no grouping election is made, each one of your rental properties is considered its own “activity”. 

Sec. 469(g) states that when “a taxpayer disposes of his entire interest in any passive activity”, any loss in excess of “any net income or gain for such taxable year from all other passive activities” shall be treated “as a loss which is not from a passive activity”.

In other words, when you sell your “entire interest” in an activity, any remaining losses left from that activity after offsetting income or gain from passive activities for the year, are non-passive and can be used to offset your non-passive income. 

For example, you have $100,000 in suspended passive losses from Property A and sell Property A for a gain of $75,000 and have no other passive income or gain for the year. Because you sold your entire interest in the activity, the $25,000 loss is treated as a non-passive loss and can potentially offset your W-2 or active business income. 

However, if you had made the grouping election under Sec. 1.469-9(g), all your rental activities are now one activity. Thus if you sold Property A and own multiple properties, you are no longer disposing of your entire interest in the activity, and the $25,000 in remaining losses are not treated as non-passive and will remain suspended. 

Something also important to note, many CPAs not well versed in this area of the tax code tend to get hung up on the “entire interest” issue and believe that when you sell a property and have made the grouping election, the losses are locked up until you sell all of your properties, and can’t even be used to offset the gain from the sale of the property. 

This is just not true as Sec. 469(f) makes it clear that losses from former passive activities can be used to the extent of income generated from the activity, and thus can offset the gain on sale.

So is the “Downside” to Making this Election Really That Bad?

In up markets generally not. This is because in markets where properties are appreciating, you often won’t have suspended losses in excess of your gain on sale if you hold the property for a few years. Meaning that there will be no remaining losses available after offsetting the gain of sale to offset your non-passive income in the first place. 

However, if you do a cost segregation study on a property and use 100% bonus depreciation in a year prior to becoming a real estate professional and make this election, then subsequently the property after owning it for a short period of time, there is the chance that you may have suspended losses in excess of your gain that will, unfortunately, remain suspended for now.

This is why we typically recommend not doing a cost segregation study on a property in the year you acquire it if you plan to become a real estate professional within the next handful of years. Instead, wait until the year you qualify as a real estate professional and have a cost segregation study performed in that year. That way, the losses will be non-passive and won’t be suspended in the first place. 

Having said that, with proper planning, this is often a non-issue. 

Also, as stated above, if you do have suspended losses from the property prior to becoming a real estate professional and make this election, then sell a property and have a gain, the suspended passive losses are generally unlocked to the extent of the gain. 

Unlike what most CPAs fear, in this case, your suspended passive losses are not useless and can be used to help minimize or eliminate the gain on sale of your properties in years when you’re a real estate professional.

The Bottom Line

As a real estate professional, in order to turn losses from your rental properties non-passive, you will often have to make the grouping election to treat all your rental properties as one for the purposes of passing one of the material participation tests. 

If you sell one of your properties after making this election, previously suspended losses in excess of the income or gain from the activity will not be unlocked to offset your non-passive income because you are no longer disposing of your “entire interest” in the activity.

However, the previously suspended passive losses can be unlocked to the extent of the income or gain from the activity and can help reduce or eliminate the gain on sale. 

For these reasons, there is often no detrimental downside to making the grouping election, and most real estate professionals will benefit from making the election. 

But as always, be sure to speak to your CPA about your specific circumstances to make sure making the grouping election makes sense for you.