Grouping Rental Real Estate Activities Under Regs. Secs. 1.469-4 and 1.469-9

Gains & Losses

When the IRS announces a change in the application of existing tax law, practitioners frequently revisit the fundamentals in the area of change so as to understand the change. One such change was under Rev. Proc. 2010-13 and the application of activity groupings under Sec. 469. Much has been written recently about the new disclosure requirements for passive activity loss groupings as established under Rev. Proc. 2010-13. This item reviews fundamental relationships of the grouping of activities under Regs. Sec. 1.469-4 and the grouping of rental real estate activities under Regs. Sec. 1.469-9. It is important to make a distinction between the two as they relate to the passive activity limitations of Sec. 469. These two activity grouping options provide opportunities for the taxpayer to lessen the negative effects of Sec. 469.

Under Regs. Sec. 1.469-4, the taxpayer can choose to group trade or business activities with other trade or business activities. In order to group any two or more activities, they must together represent an appropriate economic unit. The factors establishing an economic unit are listed in Regs. Sec. 1.469-4(c). While the “economic unit” requirement applies to all Regs. Sec. 1.469-4 activity groupings, the successful grouping of a rental activity with a nonrental activity necessitates meeting an additional requirement under Regs. Sec. 1.469-4(d).

Under Regs. Sec. 1.469-4(d), a taxpayer may not group a trade or business activity and a rental activity to form a single activity unless one of the following conditions exists:

• The rental activity is insubstantial in relation to the trade or business activity;
• The trade or business activity is insubstantial in relation to the rental activity; or
• Ownership in the trade or business activity and in the rental activity are proportionate to each other.

However, for real estate professionals, as discussed below, the rules of Regs. Sec. 1.469-9 place further restrictions for the grouping of a rental real estate activity with any other activity.

While this item addresses the differences between the two regulations from a high-level perspective, there are additional rules for limited partners, limited entrepreneurs, other activities identified by the IRS, and activities conducted through Sec. 469 entries that will not be discussed here.

Regs. Sec. 1.469-9 applies to taxpayers meeting the requirements of Sec. 469(c)(7). Throughout this discussion, these requirements will be referred to as those of a real estate professional. If during the year a taxpayer achieves the status of a real estate professional, the taxpayer may elect to treat all of his or her interests in rental real estate as a single rental real estate activity. This is a grouping election that applies only to interests in rental real estate.

The groupings under each regulation have some similarities. Both regulations have an analogous consistency requirement; the taxpayer must continue to use the grouping each year unless there is a change in the facts and circumstances that makes it clearly inappropriate. They both have prohibited groupings as well. Neither section allows a taxpayer to group real property rentals and personal property rentals as one activity.

Although these two regulations are in some ways similar as noted above, there are many characteristics that they do not share.

• Notifying the IRS of the rental real estate groupings:
  • Regs. Sec. 1.469-4: Made with a tax return disclosure statement as required by Rev. Proc. 2010-13.
  • Regs. Sec. 1.469-9: Made by election statement. Elective, as required by Regs. Sec. 1.469-9(g).
• General types of activities that can be grouped:
  • Regs. Sec. 1.469-4: Grouping of trade or business activities with rental real estate is limited by Regs. Sec. 1.469-4(d) as noted above.
  • Regs. Sec. 1.469-9: All interests in rental real estate held by real estate professionals are grouped as a single activity. There are special rules for certain management activities.
• Notifying the IRS of a change in the facts and circumstances:
  • Regs. Sec. 1.469-4: Regroup if allowed by Regs. Sec. 1.469-4, with a disclosure statement containing details of the regrouping as established by Rev. Proc. 2010-13.
  • Regs. Sec. 1.469-9: Revoke the election, as described in Regs. Sec. 1.469-9(g)(3).
• Prerequisites to making the groupings:
  • Regs. Sec. 1.469-4: The groupings must represent the appropriate economic units as outlined in Regs. Sec. 1.469-4(c).
  • Regs. Sec. 1.469-9: The taxpayer must first qualify as a real estate professional.
• Taxpayers’ flexibility with groupings:
  • Regs. Sec. 1.469-4: Great flexibility. Taxpayer may group trade or business activities and rental real estate activities if they comprise an appropriate economic unit.
  • Regs. Sec. 1.469-9: Little flexibility. All interests in rental real estate activities will be grouped as a single activity.

With respect to rental real estate, Regs. Secs. 1.469-4 and 1.469-9 do interact with each other. It is somewhat tricky to figure out how they interact, and it is easy to get confused, particularly because Regs. Sec. 1.469-9 applies only during a tax year of real estate professional status.

The two regulations rule and overrule each other as follows:

1. Regs. Sec. 1.469-9(b)(3) states that if a rental real estate activity is grouped with a non–real estate trade or business activity under Regs. Sec. 1.469-4(d)(1)(i)(A) or (C) (because the rental real estate is either insubstantial in relation to the trade or business or because of common ownership), the rental real estate is not considered an interest in rental real estate for purposes of Regs. Sec. 1.469-9. Presumably this situation can exist only when the Regs. Sec. 1.469-4 grouping was created in a year the taxpayer was not a real estate professional and prior to any real estate professional grouping election. If Regs. Sec. 1.469-9(b)(3) excludes a rental real estate activity, presumably it is also excluded from the grouping election applicable to real estate professionals. Consequently, a Regs. Sec. 1.469-4 grouping of rental real estate can overrule a 1.469-9 election grouping of rental real estate (but only for that activity).
2. Regs. Sec. 1.469-9(d)(1) states that a taxpayer’s grouping of real property trade or business activities under Regs. Sec. 1.469-4 does not control the determination of the taxpayer’s real property trades or businesses. A taxpayer’s personal services and material participation in real property trades or businesses are critical requirements of being a real estate professional. Consequently, Regs. Sec. 1.469-9 overrules Regs. Sec. 1.469-4 in the evaluation of real property trades of businesses for purposes of Sec. 469(c)(7).
3. Regs. Sec. 1.469-9(e)(3)(i) states that a real estate professional may not group a rental real estate activity with any other activity. Consequently, real estate professionals do not have at their discretion making a grouping of rental real estate under Regs. Sec. 1.469-4(d)(1)(i). Consequently, Regs. Sec. 1.469-9 overrules Regs. Sec. 1.469-4 on this point, except for the situation in No. 1 above.
4. Regs. Sec. 1.469-9(g)(1) states that in any given tax year, if a taxpayer who has made the real estate professional grouping election is not a real estate professional, the activity groupings revert to those made under Regs. Sec. 1.469-4, and Regs. Sec. 1.469-9 grouping elections shall have no effect. Consequently, Regs. Sec. 1.469-4 will overrule Regs. Sec. 1.469-9 until real estate professional status is achieved in a later year.

What does this all mean? How do these pieces fit together? All Regs. Sec. 1.469-4 rental real estate groupings with trades or businesses discussed below are assumed accomplished under Regs. Sec. 1.469-4(d)(1)(i)(A) or (C).

1. Can taxpayers group rental real estate with a trade or business under Regs. Sec. 1.469-4 if they are not real estate professionals?
   Yes, if they meet one of the three exceptions. They can group under this section even if they become real estate professionals in a future year.
2. Can taxpayers group rental real estate with a trade or business under Regs. Sec. 1.469-4 if they are real estate professionals?
   No, unless they had a previous grouping before becoming real estate professionals and the grouping was allowed because the rental was insubstantial in relation to the business or because of common ownership. However, the real estate professional has the option to group rental real estate under Regs. Sec. 1.469-9.
3. Can taxpayers group rental real estate with a trade or business under Regs. Sec. 1.469-4 if they are not real estate professionals in the current year but were in a previous year and have a grouping election under Regs. Sec. 1.469-9 in effect?
   Yes, but the Regs. Sec. 1.469-4 grouping of rental real estate with other trades or businesses will not be effective during the years the taxpayer is a real estate professional.
4. Can taxpayers group rental real estate with a trade or business under Regs. Sec. 1.469-4 if they are not real estate professionals in the current year but were in a previous year and do not have a grouping election under Regs. Sec. 1.469-9 in effect?
   Yes (with the same restrictions as in No. 1), and it will continue to be effective in years the real estate professional status exists even if they make the election in future years.

The consequences of not grouping related trade or business activities could be years of suspended losses held up in the tax return due to the difficulty of establishing material participation for each separate activity. The same is true for not making the rental real estate professional grouping election. There are two recent Tax Court cases involving taxpayers who thought that presenting their rental activities on one schedule was sufficient notice that they were grouping their rental properties as a single rental activity (Sheikh, T.C. Memo. 2010-126, and Trask, T.C. Memo. 2010-78). This is not the case when it comes to Regs. Sec. 1.469-9; the taxpayer must make the election.

The regulations discussed in this item can be easily confused when grouping rental real estate activities, so it is necessary to differentiate between the two. In order to be a valuable resource to clients as tax practitioners, it is essential for advisers to fully understand the differences, similarities, and interrelationships of these two regulations so they can properly plan for their clients’ future with the goal of minimizing their tax liability.

EditorNotes

Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.

For additional information about these items, contact Mr. Koppel at (781) 407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.