Using Real Estate Grouping Elections to Offset Income

Instead of letting your real estate losses sit unused on your tax return, a simple election can let them offset your business income or your salary

Case Study Summary

A real estate investor with multiple properties was generating significant depreciation deductions — but under the passive loss rules, those losses were stuck on his tax return, unable to offset his other income. A grouping election changed everything.

Background: Why Do Real Estate Losses Get Stuck?

Real estate is one of the most tax-friendly investments there is.

Depreciation lets you deduct the cost of a building over time, and cost segregation lets you deduct a large chunk of it right away. A property that makes money can easily show a large loss on paper.

But most people find out the hard way that those losses don’t do much for them.

The tax code treats rental real estate as “passive.” Passive losses can only offset passive income. They can’t touch your business profits or your salary.

There’s a small exception: up to $25,000 of rental losses can offset other income. But it phases out between $100,000 and $150,000 of income, so most high earners get none of it.

So the losses get suspended, year after year, until you sell the property.

Is there a way to use them now?

And the answer is a grouping election.

What Is a Grouping Election?

The tax code doesn’t just look at whether an investment is passive. It looks at each “activity” separately.

A grouping election tells the IRS to treat two or more activities as one.

That matters because once activities are grouped, they’re tested together. If you’re actively involved in the combined activity, the losses from every part of it are no longer passive.

There are two grouping elections that matter most:

1. The self-rental grouping election, for business owners who own the building their business operates in.
2. The real estate professional aggregation election, for investors (or their spouses) who work in real estate full-time.

Let’s look at each one.

What If I Own the Building My Business Uses?

Many business owners buy their own building and have their business pay rent to it. It’s a common way to build wealth: the business pays down your mortgage instead of a landlord’s.

But it comes with a tax trap called the “self-rental rule.”

When you rent a building to a business you’re actively involved in:

• If the building makes money, that income is treated as active, so it can’t absorb passive losses from your other investments.
• If the building loses money, that loss stays passive, so it can’t offset your business income.

Heads you lose, tails you lose.

The fix is to group the building and the business into a single activity. To qualify, the owners of the business must own the building in the same proportions. If you own 100% of the business and 100% of the building, you qualify. Married couples filing jointly count as one owner.

Let’s look at a quick example.

Let’s say your business earns $800,000 a year, and you buy a $2 million building for it through a separate LLC. Of that, $400,000 is land. A cost segregation study identifies $400,000 of short-life components you can deduct in year one with bonus depreciation.

First-Year Results From the Building

The building brought in $50,000 more than it cost to run, but shows a $380,000 tax loss because of depreciation.

Here’s what that loss is worth, with and without the grouping election, at a combined federal and state tax rate of about 45%:

Taxes With and Without the Grouping Election

Without the election, the $380,000 loss sits unused. With it, the loss offsets your business income and saves $171,000 in the first year.

What If My Spouse or I Work in Real Estate Full-Time?

If you qualify as a real estate professional, your rental losses aren’t automatically passive.

To qualify, one spouse has to spend more than 750 hours a year in real estate, and more than half of their total working time.

But qualifying as a real estate professional isn’t enough on its own. You still have to materially participate in your rentals, and the IRS tests each property separately.

That’s a problem if you own several properties, because your hours are spread across all of them.

The solution is the aggregation election, which lets a real estate professional treat all of their rentals as a single activity.

Let’s say a physician’s spouse manages their six rental properties full-time, spending about 150 hours on each one. The most common material participation test requires 500 hours.

Material Participation With and Without the Aggregation Election

Without the election, no single property meets the 500-hour test, and every loss stays passive. With it, the 900 combined hours qualify, and the losses from all six properties can offset the physician’s salary.

What’s the Catch?

Grouping elections are powerful, but they come with rules you have to get right:

• You have to make the election on time. The grouping has to be disclosed on a timely-filed original tax return. Without the statement, the IRS treats the activities as separate.
• It’s hard to undo. Once you group activities, you generally can’t regroup them later. The aggregation election can only be revoked if your circumstances materially change.
• It’s all or nothing for real estate professionals. The aggregation election covers every rental you own. You can’t pick and choose.
• It delays your suspended losses. Because the grouped properties count as one activity, selling one property doesn’t free up its suspended losses. They’re released when you dispose of substantially all of the activity.
• Depreciation still gets recaptured. As with any real estate depreciation, you pay it back when you sell, unless you hold until death and your heirs get step-up in basis (see “Passing Wealth Tax-Free Through Step-Up In Basis”).

Who This Strategy Is Best For

• ✓Real estate investors with multiple rental properties
• ✓Medical, dental, and professional practices that own their office
• ✓Couples where one spouse works in real estate full-time
• ✓Investors with multiple rental properties and suspended losses
• ✓Investors whose rental activities generate significant depreciation