Grouping of Activities
By: Robert Taylor
A typical ownership structure for an owner-occupied commercial building is the business and building held in separate entities. The business is held in a trade or business entity, and the building that houses the business is held in a separate real estate rental entity. The trade or business entity pays rent to the real estate rental entity. An example would be a doctor who owns a building from which he operates his practice. His practice is held in a trade or business entity, and the building is held in a real estate rental entity. This structure is usually done for liability reasons.
The issue with this structure from a cost segregation perspective is losses in the real estate rental entity are considered passive losses, which would not offset active income, which is income made in the trade or business entity. There is little passive income to offset in most cases, so the deductions generated from the cost segregation become suspended and cannot immediately be used.
There is a solution for this. It is called “Grouping of Activities” and can be found in §1.469-4. A rental activity usually cannot be grouped with a trade or business activity unless the two activities form an “appropriate economic unit.” The factors for determining an appropriate economic unit are the following:
- Similarities and differences in the types of businesses
- The extent of common control
- The extent of common ownership
- Geographical location
- Interdependencies between the activities
In addition to being an appropriate economic unit, the rental activity has to be insubstantial to the trade or business activity (and vise versa). Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.
In most cases, an owner-occupied building would meet these qualifications and would be eligible to be grouped with the business activity. Going back to the doctor example, as long as there are common control and ownership in the trade or business and the rental activity, this would be eligible to be grouped.
Once the activities are grouped together, any losses generated from the rental activity would no longer be subject to the passive loss limitations, and they would become fully deductible.
To group activities, it is merely an election that is made on the tax return. In most cases, it is necessary to group the activities in the first year the building is placed into service. The reason is if a return is filed without the activities being grouped, and election not to group has been made. This cannot be changed unless the original grouping was clearly inappropriate or a material change that made the original grouping clearly inappropriate.