Making the Real Estate Professional Grouping Election

Under the passive activity loss (PAL) rules, rental real estate is considered a passive activity. This means losses from rental properties can only offset income from other passive activities, not non-passive sources like a salary. For individuals with a modified adjusted gross income over $150,000, the ability to deduct rental losses is often eliminated.

An exception to these limitations is achieving “real estate professional” (REP) status, which allows a taxpayer to treat their rental activities as non-passive. This enables the deduction of rental losses against all forms of income. However, qualifying requires a substantial time commitment.

Meeting these requirements often involves the grouping election, permitted under Internal Revenue Code Section 469. This election allows a taxpayer to combine multiple real estate interests into a single activity. This aggregation is often necessary to satisfy the material participation tests and unlock the benefits of the REP designation.

Qualifying as a Real Estate Professional

To be recognized by the IRS as a real estate professional, an individual must satisfy two quantitative tests each year. The first is the “more-than-half personal services test,” which requires that more than 50% of the total time the taxpayer spends working in all trades or businesses must be in real property trades or businesses.

The second requirement is the “750-hour test,” which mandates that the taxpayer perform more than 750 hours of service in real property trades or businesses. These trades include activities like property development, construction, acquisition, rental, operation, management, leasing, or brokerage. For married couples filing jointly, only one spouse needs to meet both tests.

After qualifying as a real estate professional, the taxpayer must also prove they “materially participated” in their rental activities. The IRS provides seven tests for material participation, but three are most common for real estate. The most definitive is working more than 500 hours in the activity during the year.

Another test is if the taxpayer’s participation constituted substantially all of the participation in the activity. A third test is participating for more than 100 hours, provided this is not less than the participation of any other individual. The challenge is that the IRS views each rental property as a separate activity, making it difficult to meet a material participation test for each one, which is the problem the grouping election solves.

Understanding the Grouping Election

The grouping election is a formal statement on a tax return to treat multiple real estate activities as a single, combined activity. Its primary function is to help real estate professionals meet the material participation tests by aggregating hours spent across several properties.

For a grouping to be valid, the chosen activities must form an “appropriate economic unit.” Factors to consider include the extent of common control and ownership, similarities of the businesses, geographical location, and interdependencies between the activities. A taxpayer has flexibility in applying these factors, but the grouping must be reasonable and consistently applied.

Consider a real estate professional who owns three rental properties, spending 200 hours on Property A, 175 on Property B, and 150 on Property C. Individually, none meet the 500-hour material participation test, and the losses would remain passive.

By making a grouping election, the taxpayer combines all three into a single activity. The total time spent is 525 hours, which exceeds the 500-hour threshold. As a result, the combined net loss from all three properties becomes non-passive and can offset the taxpayer’s other income.

How to Make the Grouping Election

Information and Documentation Required

A taxpayer must prepare a formal statement to include with their tax return. This taxpayer-created document must contain a clear description of each rental real estate activity being grouped, including property addresses. The statement must also declare that the grouped activities constitute an appropriate economic unit.

While the statement does not require a lengthy justification, the taxpayer must be prepared to defend the determination if audited. This defense relies on contemporaneous documentation. Taxpayers should maintain detailed records, such as time logs or calendars, that specify the hours, dates, and descriptions of services performed.

Filing the Election Statement

The election is made by attaching the prepared statement to a timely filed original income tax return for the first year the election is to take effect. A taxpayer cannot retroactively group activities for a prior year by amending a return. The decision and statement must be part of the original filing for the year the grouping begins.

Failure to include this statement means no valid election was made. The IRS will then continue to treat each rental property as a separate activity, likely resulting in the disallowance of rental losses against non-passive income.

Key Implications of the Election

Binding Nature

Once an election is made to group real estate activities, the decision is binding for all subsequent tax years. A taxpayer must continue to report the combined properties as a single activity. This consistency requirement prevents regrouping activities simply to manipulate tax outcomes.

The grouping must remain in place unless a material change in facts and circumstances makes the original grouping inappropriate. A material change could include a significant shift in property ownership or the nature of business operations. A desire to achieve a better tax result is not considered a material change.

Revoking the Election

If a material change in facts and circumstances occurs, a taxpayer can revoke the election. To do so, they must file a statement with their tax return for the year of the change. This statement must identify the original group and explain the material change that justifies the revocation.

Rules on Property Dispositions

A significant consequence of the grouping election emerges when a taxpayer disposes of one property from within the group. When activities are grouped, the sale of a single property is not considered a complete disposition of the entire activity.

This means any suspended losses tied to that specific property are not released by the sale. The losses remain suspended and can only be used to offset future passive income from the remaining properties in the group. Suspended losses are only fully released when the taxpayer disposes of their entire interest in all properties within the grouped activity.