Rental Property Grouping Election

Rental property grouping election is the choice, described in IRS Publication 925, to treat one or more trade or business activities or rental activities as a single activity when they form an appropriate economic unit for measuring gain or loss under the passive activity rules. It is a tax grouping. It is not a loan product, it does not change your rent roll, and it is not an hour test. Publication 925 states the material-participation tests elsewhere. This article does not copy them. An inquiry is not a tax opinion or an approval.

Grouping matters because of two consequences the publication states directly. If you group two activities into one, you need only show material participation in the activity as a whole. If they stay separate, you must show it in each. If you group them and later sell only one, you have disposed of only part of the activity. If they stay separate and you sell one, you have disposed of your entire interest in that activity. Those are the stakes. A casual “I have a portfolio” sentence on a return is not the election.

Rental property grouping election under Publication 925

Publication 925 says you decide whether activities form an appropriate economic unit from all the relevant facts. You may use any reasonable method of applying those facts. Not every factor has to be present. The factors the publication gives the greatest weight are:

• Similarities and differences in the types of trades or businesses
• The extent of common control
• The extent of common ownership
• Geographical location
• Interdependencies between the activities

Interdependencies, in the publication’s list, can include the extent to which the activities buy or sell goods among themselves, offer products or services that are generally provided together, share customers, share employees, or use a single set of books. Two rentals on one street with one manager and one set of books present a different set of facts from two rentals in distant markets with separate managers and separate books. The publication’s own examples show that more than one grouping can be reasonable. This page will not pick the grouping for a portfolio it has not seen.

The publication also says grouping can matter for the ownership test used in active participation in a rental real estate activity. It states that you are not treated as actively participating unless your interest, including your spouse’s, was at least 10 percent by value of all interests in the activity throughout the year. That 10 percent figure is the publication’s ownership test, not a financing loan-to-value cap, and not a dollar threshold. How the special allowance works beyond that test is in Publication 925. This article does not restate dollar limits from the allowance.

What you generally cannot group

In general, Publication 925 says you cannot group a rental activity with a trade or business activity. You can group them if they form an appropriate economic unit and one of three things is true. The rental activity is insubstantial in relation to the trade or business. Or the trade or business is insubstantial in relation to the rental. Or each owner of the trade or business has the same ownership interest in the rental activity, in which case the part of the rental activity that involves renting property for use in the trade or business may be grouped with the trade or business.

The publication’s grocery-store example is the pattern for that third path. One spouse owns the operating company. The other owns the company that rents the building to the store. They file jointly, so they are treated as one taxpayer for these rules, and the ownership interest in each company is the same. If the grouping is an appropriate economic unit, they may group the store rental with the store business. A landlord who owns rentals and also owns an unrelated operating company should not assume that example applies. The ownership match and the economic-unit facts both have to be there.

In general, you also cannot treat a real-property rental and a personal-property rental as one activity. You can if you provide the personal property in connection with the real property, or the real property in connection with the personal property. A furnished rental may raise that sentence. A separate equipment-leasing business usually does not.

Two limits catch investors who hold through entities. A partnership or an S corporation groups its own activities under these rules. You may not treat activities the entity grouped as separate activities. You may group the entity’s activities with each other, with activities you conduct directly, or with activities you conduct through other entities, if the publication’s rules allow it. You may not group activities conducted through a publicly traded partnership with any other activity, including another publicly traded partnership. How a real estate partnership is structured is the ownership conversation. It does not file the grouping statement for you.

Passive activity loss rules still sit underneath the grouping. Grouping changes the unit you measure. It does not repeal the passive-loss limits. A real estate professional election to treat all interests in rental real estate as one activity is a different election, described in Publication 925 under real estate professional rules and the Instructions for Schedule E. Real estate professional status is that status. Its service tests are in the publication. This page does not restate them. Passing a grouping test does not make you a real estate professional.

Consistency, disclosure, and the financing file

Publication 925 says that once you group activities into appropriate economic units, you generally may not regroup in a later year. You must meet the IRS disclosure requirements when you first group and when you add or dispose of activities in your groupings. If the original grouping is clearly inappropriate, or a material change in the facts makes it clearly inappropriate, you must regroup and disclose. If a grouping is not an appropriate economic unit and one of the primary purposes of the grouping, or of a failure to regroup, is to avoid the passive activity rules, the IRS may regroup the activities.

For the disclosure itself, the publication says you file a written statement with the original return for the first tax year in which two or more activities are originally grouped. The statement gives the names, addresses, and employer identification numbers, if applicable, for the activities being grouped. It includes a declaration that the grouped activities make up an appropriate economic unit for measuring gain or loss under the passive activity rules. Adding a new activity to a group, or regrouping, has its own statement, described in the same section. If you fail to report changes the publication requires, each trade or business activity or rental activity is treated as separate. Partnerships and S corporations follow the disclosure instructions on their own returns. A partner or shareholder makes a separate disclosure only in the cases the publication lists, including when the partner groups the entity’s activities with activities the entity did not group together.

That statement is a tax filing. A business-purpose loan file will not treat it as a rent roll or as collateral. Building a rental portfolio is the operating question of how many properties you hold and how you manage them. You can own several rentals, finance them as investment properties, and still leave them ungrouped for tax. You can group them for tax and still finance each one on its own leases. Whether rental income is subject to self-employment tax is a separate question from grouping. Do not expect a capital provider to ask for your grouping statement, and do not expect the statement to change a DSCR or a commercial coverage test.

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Frequently Asked Questions

Can I group all of my rentals by default?

No. Publication 925 lets you treat rental activities as one activity when they form an appropriate economic unit under the factors it lists, and separate markets, separate control, and separate books can support leaving them apart. A real estate professional’s election to treat all rental real estate as one activity is a different election in the same publication. Neither one happens because you own more than one house.

Can I group a rental with my operating business?

In general, no. Publication 925 allows it only when the activities form an appropriate economic unit and the rental is insubstantial relative to the business, the business is insubstantial relative to the rental, or each owner of the business has the same ownership interest in the rental activity. The last path is the one the publication illustrates with a store and the building rented to that store. Match the facts before you group.

Can I change the grouping next year?

Generally, no. Publication 925 says you may not regroup in a later year once you have grouped into appropriate economic units. You must regroup if the original grouping is clearly inappropriate or a material change makes it so, and you must disclose. The IRS may also regroup activities when the publication’s avoidance standard is met, so plan the first grouping as if it will stick.

What goes in the disclosure statement?

For a new grouping, Publication 925 says the statement filed with the original return names the activities, gives addresses and EINs if applicable, and declares that the grouped activities are an appropriate economic unit for the passive activity rules. Additions and regroupings have their own statements in that section. If required changes are not reported, the publication treats each activity as separate.

Does a grouping election change my loan?

It changes the tax unit you measure under the passive activity rules. It does not change rent, a lease, or the collateral. Business-purpose financing still reads the property and the income the program uses, and a grouping statement is not an approval or a substitute for a rent roll. File it for the return, and keep it out of the story you tell a reviewer about this year’s leases.