In the United States, when you are a real estate professional, you can make an election on your tax return to treat all your real estate items like they are rental properties and categorize them as one activity. This process is called grouping. But what is grouping passive activities, and how will this benefit you?
Let’s say that you have ten rental properties. You can group those and consider them as one activity. People practice grouping passive activities to help meet a requirement to be considered a real estate professional in the US. You can deduct real estate losses against all your other income.
How Does Grouping Passive Activities Work?
Grouping passive activities is specifically geared toward real estate professionals. Let’s say you invest in 10 rental properties. You currently have $150,001 in income from a W-2 job and on paper, all those properties result in a $150,000 loss due to some tax planning. As a qualified real estate investor or at the time of writing this, short term rentals, you can choose to group all your rentals together as one asset and deduct the entire $150,000 loss against your $150,001 W-2 income to show nearly $0 in taxes.
There are benefits and downsides to grouping activities. When you group that particular activity, it helps you be classified as a real estate professional. Most people want to be considered as such because of the tax benefits.
A taxpayer is able to group passive activities if they have a material change in status or qualify under other Treas. Reg. 1.469 guidance. This is a large benefit because if a tax payer decides to group and qualifies this will then allow for the use of suspended losses in the year they sale a single rental. In addition thanks to IRC Section 469 they might also be able to use suspended losses from other rentals to offset this gain.
What is the Downside of Grouping Passive Activities?
The major disadvantage of grouping passive activities is that they are forever grouped, in most cases. This means that they are always going to be grouped. It is an issue when you decide to sell a property that has suspended losses.
If you sell one of those 10 properties, you cannot use those suspended losses, which cannot be used to reduce your gains. These losses can only be used when the IRS code section 469 allows. Either you sell all of the 10 properties to use the suspended losses.
Do Individuals Actually Opt Out of Grouping Passive Activities?
Some elect not to group activities because they want to take advantage of the suspended losses they can have on a property in the future or they simply don’t qualify to group passive activities. When they get ready to sell, they want to make the most of that. A workaround for this is the Treasury Regulation 1.469-11 and -4.
What is the Treasury Regulation 1.469?
Treasury Regulation 1.469 refers to a specific regulation issued by the U.S. Department of the Treasury under Section 469 of the Internal Revenue Code (IRC). Section 469 of the IRC addresses the treatment of passive activity losses and credits for individual taxpayers and closely held businesses.
The purpose of Treasury Regulation 1.469 is to provide guidance and rules for determining whether an individual or business activity is classified as passive and how the related losses and credits are treated for tax purposes. The regulation helps determine whether losses from passive activities can be deducted against income from other sources or whether they are subject to certain limitations.
Key Provisions and Concepts of Treasury Regulation 1.469?
The regulation defines passive activities as any trade or business in which the taxpayer does not materially participate. Material participation is generally determined based on the taxpayer’s level of involvement in the activity.
Passive Activity Losses:
Passive activity losses are losses incurred from passive activities. The regulation outlines rules for deducting these losses against other income and limitations on the number of passive losses that can be offset against non-passive income.
Passive Activity Credits:
The regulation addresses the treatment of passive activity credits, credits generated from passive activities. It provides guidance on utilizing these credits and any limitations that may apply.
Grouping of Activities:
Treasury Regulation 1.469 allows taxpayers to group certain activities to determine material participation and treat passive losses and credits. The regulation specifies criteria and rules for making activity groupings.
Real Estate Professionals:
The regulation includes provisions related to the treatment of real estate professionals, who may be able to avoid the general passive activity loss limitations if they meet certain criteria regarding their involvement in real estate activities.