In the article regarding qualifying to be a professional real estate professional, the article said: if you own more than one rental property, you can make an election to treat the properties as one activity. Making this election can make it easier to meet the hour requirements under the material participation tests but can have disadvantages when you sell the property. Can you please help me understand how it is a disadvantage when you go to sell the property?
-Todd, California
Hello Todd,
Thank you for your question regarding our previous blog on the real estate professional tax (RE pro) status. In that blog, we explain some of the advantages and disadvantages of the real estate professional status and who would qualify for that status on their tax return. We mention that electing to group properties together into one activity to qualify for real estate professional status comes with some disadvantages, particularly when it comes to selling the rental property(ies). You are looking for clarification on what these disadvantages are. Hopefully, this will answer your question.
As we mentioned in that previous blog, the RE Pro status allows you to claim your full losses on your rental real estate activities. This status is only advantageous if your rental properties incur net losses during the tax year, as it doesn't generate any tax benefits when the properties show net profits. If you don't qualify as a real estate professional, then rental property losses are subject to the passive activity rules and are limited by your other income. Briefly, what that means is if your income goes over $100,000, your allowable losses from your real properties will be limited; and if your income goes over $150,000, your losses are not allowed at all. You can read more about those limits in this blog. The good news is that these losses are not lost forever. They can be used to offset net rental income in future years. Any loss that remains in the year you sell the property can be used to help offset any possible gains on the sale.
Because the real estate professional status requires you to show that you materially participate in your rental activities, we also cover material participation in the blog. Material participation largely depends on the number of hours you spend performing services in your rental activity, and you must meet the material participation test on each rental property to claim RE Pro status. We mention there is an election to group your rental activities into one (or more) activities in order to meet the material participation requirements. This allows you to meet the material participation hours for the group as a whole, rather than for each property. That makes it much easier to show material participation when you own multiple properties. Otherwise, the taxpayer must show material participation in every single passive activity/property. While there are advantages to grouping activities, such as being able to meet material participation, there are disadvantages as well, and this is what you want more information on.
Before we go into why grouping activities may not be a good idea, let's discuss what's involved in actually grouping activities. You can treat one or more rental activities (or trades or businesses) as a single activity if they constitute what the IRS refers to as “an appropriate economic unit.” This is a “facts and circumstances” test and there is no hard rule on what kind of activities can be grouped. Generally, you cannot group rental real estate activities with self-employment activities. For example, you could not group your ownership of a single-family home that you rent out with your self-employed consulting business. When determining if the group is an appropriate economic unit, you should give the greatest weight to five factors:
- the similarities or differences in types of businesses or properties;
- the extent of common control;
- the extent of common ownership;
- geographical location; and
- interdependencies between the activities.
The IRS is
not obligated to accept your grouping of an activity if it should be questioned in an audit. To group the activities, you must file a statement with the tax return for the first year in which you are treating the activities as a single activity, identifying the activities, and identifying the group(s) each activity belongs to. It is probably a good idea to do this every year, although it is only required the first year and any time you change the group. Once you group the activities, you must be consistent in the treatment of these activities as a group and, in subsequent tax years, you cannot separate the properties within the activity at will or in such a manner that it produces the most beneficial tax benefits. If you add properties to the group, you need to file a new statement with your tax return to indicate the new property is part of an existing group.
The only time the IRS permits you to regroup activities is when your original grouping was clearly inappropriate, or a material change has occurred that makes the original grouping improper. And generally, for purposes of the real estate professional status, you cannot group rental real estate activities with any other activity.
The
primary disadvantage in grouping rental real estate activities is that any passive losses that are incurred in a grouped activity cannot be claimed until the
entire activity is disposed of. Remember, under the passive loss rules, you can only claim your suspended passive losses when you either have passive income, or you
completely dispose of the activity. So, when the property is sold, the taxpayer can claim the suspended losses at that time. However, when you group your rental properties into one activity, the losses can only be freed up when
all the properties in the group activity have been disposed of. Another disadvantage would be if you want to perform a like-kind exchange on a property in the group; in that case, you may need to exchange the entire group, rather than just a portion of it.
For example, let's assume that you own five rental properties. You have grouped three of these rental properties into a single activity, and that activity is generating substantial losses. The other two properties are showing small profits and are not grouped. You decide to sell one of the grouped properties so that you can invest in another property. When you sell the property, the suspended passive losses from that activity cannot be used (although any gain on the sale must be included in income). Instead, the suspended passive losses continue to be carried forward until the other two properties in that activity group have been disposed. Remember, the activity must be completely disposed of to claim the suspended losses, and that means all the activities in a grouped activity. There is an exception when a substantial portion of the group is disposed of if it constitutes “substantially all” of the group activity, but that may be hard to establish.
You may be thinking to yourself, “Why would I have suspended passive losses if I meet the real estate professional status? Doesn’t that mean the activity is no longer passive, so I won’t have suspended passive losses?” Maybe, if you can actually meet the RE Pro requirements every single year. Keep in mind that the real estate professional status is not an election where you are “one and done,” like electing to claim bonus depreciation; it can be satisfied in one year, but not in another year. Because of the hour requirements for this status, it is possible to qualify in one year but not qualify in the next year, then qualify again in the following year and so on. Qualifying one year does not automatically qualify you for subsequent tax years. And it is frequently challenged by the IRS in an audit. More commonly, taxpayers will go back and forth between the real estate professional status from tax year to tax year due to the number of hours required and, in years they do not qualify, any losses incurred are passive losses. Those losses are suspended in years when you do not meet the real estate professional status and are not allowed in years where you do meet the real estate professional status, as passive losses can only offset passive income. Because the RE Pro status removes your activity from the passive rules in a year it applies, passive suspended losses in a previous year cannot be used against any income claimed as a real estate professional. The passive losses will be released once the entire grouped activity is disposed of.
We hope this clarifies your follow-up question, but, as always, if you have questions regarding your particular tax situation, you should consult with a competent tax professional such as an Enrolled Agent, CPA, or tax attorney.
Best wishes,
Carolyn Richardson, EA, MBA