Making the Self Rental Grouping Election

The self-rental grouping election is a tax planning tool for business owners who rent real estate they own to their operating companies. This arrangement, known as a self-rental, can create a conflict with the passive activity loss rules under Internal Revenue Code (IRC) Section 469. Normally, the IRS recharacterizes net income from a self-rental as non-passive, while any net losses remain passive, preventing them from offsetting business income.

The grouping election resolves this by allowing a taxpayer to treat the rental and business as a single activity for tax purposes. This combines their income and losses, potentially turning suspended passive losses into deductible non-passive losses.

Qualifying for the Grouping Election

To group a self-rental with a trade or business, the combined activities must form an “appropriate economic unit” under Treasury Regulation § 1.469-4. This is determined by a facts-and-circumstances test that considers several factors, including:

• Similarities between the businesses
• The extent of common control
• The extent of common ownership
• Geographical location
• Interdependencies between the activities

In a self-rental scenario, the interdependence between the property and the operating business often satisfies this standard.

Common ownership and control between the rental property and the operating business is a requirement. The taxpayer or ownership group must maintain the same proportionate ownership interest in both activities. For example, if an individual owns 100% of an S corporation and 100% of the LLC that holds the real estate, the ownership test is met.

The regulations also prevent grouping if one activity is “insubstantial” in relation to the other. This rule is designed to stop taxpayers from attaching a minor activity to a large one simply to manipulate the character of its income or losses. The determination of what is insubstantial is based on an analysis of the relative income, deductions, and assets of each activity.

The election can be made by individuals, C corporations, S corporations, and partnerships. However, an individual owner cannot group their personal rental activity with the business activity of their C corporation. For partnerships and S corporations, the entity itself makes the election, and the partners or shareholders must report their income or loss consistently with the entity’s choice.

Required Information for the Election Statement

To make the self-rental grouping election, a taxpayer must prepare and file a formal statement with their tax return for the first year the election is effective. This statement, guided by Revenue Procedure 2010-13, is not a specific IRS form but a detailed disclosure. It serves as the official declaration of the taxpayer’s intent to group activities.

The statement must identify the names, addresses, and Employer Identification Numbers (EINs) for both the rental and business activities being grouped. For instance, it would list the legal name and EIN for the LLC that owns the property and for the S corporation that leases it.

The document must also include a declaration that the grouped activities constitute an appropriate economic unit under Section 469. The taxpayer must provide a brief explanation supporting this claim, often by describing the interdependencies between the activities, such as the rental’s purpose being to provide space for the business.

Finally, the statement must name the controlling taxpayer making the election. In situations involving pass-through entities like S corporations or partnerships, the entity itself is named as the one making the election, and its owners are bound by that choice.

Making and Maintaining the Election

The election is made by attaching the prepared statement to a timely filed original tax return, including extensions, for the first year the grouping takes effect. This election cannot be made retroactively on an amended return, so careful planning is necessary to complete it correctly in the initial year.

Once a taxpayer chooses to group activities, that decision is binding for all subsequent tax years unless a material change in facts and circumstances makes the grouping inappropriate. The taxpayer must consistently report the income and losses from the rental and business as a single, combined activity on future returns.

A taxpayer cannot revoke the election simply because it becomes tax-advantageous to do so. The IRS requires a material change, such as the sale of one of the activities or a significant change in ownership, to justify breaking the group. The taxpayer must disclose the revocation to the IRS and explain why the original grouping is no longer appropriate.

Because the election is a long-term commitment that is difficult to undo, the decision should be based on a long-range projection of the financial performance of both activities, not just the tax consequences of a single year.

Impact on Income and Loss Characterization

The primary effect of a grouping election is the recharacterization of income and losses. Before the election, net income from a self-rental is treated as non-passive, while net losses are treated as passive. This prevents rental losses from offsetting active business income, and the income cannot be offset by other passive losses.

Once grouped, the rental and business are treated as a single activity. If the taxpayer materially participates in the combined activity, the entire group is considered non-passive. As a result, the net income from the rental component is no longer subject to the self-rental recharacterization rule and is simply part of the larger non-passive activity’s income.

When the rental activity generates a net loss, it is combined with the income or loss from the operating business after the election. If the combined activity has a net loss, that loss is characterized as non-passive. This allows the loss to be deducted against other non-passive income sources, such as salary or investment income, subject to basis and at-risk limitations.

Consider a business owner who has $100,000 of income from their operating S-corporation and a $20,000 net loss from the LLC that rents the building to the business. Without the election, the $20,000 loss is a suspended passive loss. With a valid grouping election, the $20,000 rental loss can offset the business income, and the owner’s taxable income from the combined activity is now $80,000.