Overview
Cost segregation can provide valuable accelerated depreciation deductions to offset current income subject to higher marginal tax rates. However, taxpayers should be aware of the limitations on the current deduction of passive activity losses (PALs) and how those limitations can affect the benefits of a cost segregation study on rental real estate.
Passive activities are trades or businesses in which the taxpayer does not materially participate, and except for the rental real estate activities of real estate professionals, any rental activity is automatically treated as a passive activity regardless of the taxpayer’s level of participation.
This is an important consideration for rental real estate owners/investors because PALs are not deductible to the extent they exceed passive activity income.
Example 1
A taxpayer is in the business of medicine and materially participates in a medical practice he owns with his partners. The taxpayer and his partners conduct the medical practice under one LLC and own the building housing the medical practice under a separate LLC. The taxpayer’s share of income from the medical practice is $500,000 for the year. The LLC that owns the building receives rent from the medical practice, and after accounting for interest, depreciation, and all other operating and maintenance expenses, reported a loss for the taxable year. The taxpayer’s share of the loss is $100,000. To deduct the $100,000 loss from the rental activity against the $500,000 of income from the medical practice, the taxpayer must generally be a real estate professional and they must materially participate in the rental activity. This can be a high bar to meet, as we will show.
Material participation means involvement in the operation of the activity on a basis which is regular, continuous, and substantial. This definition is very vague, but seven tests have been developed through the courts and by regulation that determine if a taxpayer materially participates in an activity. See Treas. Reg. §1.469-5T. The most common test is whether the individual taxpayer participated in the activity for more than 500 hours during the taxable year.
From Example 1, the taxpayer performs no less than 2,000 hours (50 wks X 40 hrs/wk) of personal services in the medical practice activity during the taxable year, so it is clearly not a passive activity for the taxpayer. However, for the rental activity to be nonpassive, the taxpayer must satisfy a higher bar than for their non-rental activities.
First, they must be a real estate professional. A real estate professional is a taxpayer that performs more than one-half of their total personal services during the taxable year in real property trades or businesses in which they materially participate, and such services total more than 750 hours of services during the taxable year. A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.
In Example 1, the taxpayer would have to perform more hours of personal services in material participation real property trade or business activities than they perform in the medical practice (2,000+ hrs), which would be all but impossible.
Second, even if the taxpayer satisfies the requirements to be a real estate professional, they must satisfy one of the seven material participation tests for the specific rental real estate activity. Even though a real estate professional’s rental real estate activities aren’t per se passive activities, whether those rental activities are passive is still determined under the same rules that apply to non-rental activities. However, a real estate professional can elect to treat all their interests in rental real estate as a single rental real estate activity under Treas. Reg. §1.469-9(g), which should help to prevent any of the rental activities from being classified as passive.
For non-real estate professionals, another grouping election may be available to prevent the rental activity from being classified as a passive activity. Generally, a rental activity may not be grouped with a trade or business activity for purposes of analyzing a taxpayer’s participation in the activity. However, if the rental activity and the trade or business activity constitute an appropriate economic unit (a facts and circumstances analysis based on control, ownership, location, and interdependencies), and each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity. See Treas. Reg. §1.469-4(d)(1)(i)(C).
Revisiting Example 1, if the taxpayer and his partners have the same proportionate ownership interests in both the medical practice and real estate entities, there are no other tenants of the building, and the election to group the rental activity with the medical practice has been properly made (see Rev. Proc. 2010-13), the rental activity will no longer be a passive activity for the taxpayer, and the $100,000 loss will offset the $500,000 of medical practice income.
Alternatively, if the grouping election is unavailable because the partners’ proportionate ownership interests in the medical practice and the real estate entity vary, the medical practice could purchase the building from the real estate entity thereby extinguishing the rental activity altogether.
