limitations when electing rental RE activities into one activity?

Question

With respect to real estate professional status, are there any limitations or traps for the unwary when electing to aggregate rental real estate activities into one activity pursuant to Code Sec. 469(c)(7)(A) and Reg. §1.469-9? More specifically, my husband and I already own several rental properties together in several LLCs. We are now considering joining forces with a friend to buy additional long-term rental properties. We will be actively involved in the activity. We are not sure whether this new venture will be a (general) partnership, s-corporation, LLC, or how it will be structured. The question is whether the structure we choose will impact our aggregation election under Regs. Sec. 1.469-9(g).

Thanks!

Ashish Acharya · Answer

Good Question.

You don't have to group new activities with the ones you have already in a group. This is a complicated area and there are things that you wouldn't know if you are not a tax professional. Sorry for the long reply.

A taxpayer's interest in rental real estate held by a partnership or an S corporation is treated as a single interest in rental real estate if the partnership or S corporation grouped its rental real estate as one rental activity under Reg. 1.469-4(d)(5). If the partnership or S corporation groups its rental real estate into separate activities, each rental real estate activity is treated as a separate activity for the partner or shareholder. However, the partnership's or S corporation's separate activities can be regrouped into one activity at the owner level if elected [Reg. 1.469-9(h)(1)].A special rule applies if a taxpayer holds a 50% or more interest in the capital, income, gain, loss, deduction, or credit of a partnership or S corporation at any time during the tax year. In such case, each interest in rental real estate held by the partnership or S corporation is treated as a separate activity for the taxpayer, despite the partnership's or S corporation's grouping of the activities. The qualifying taxpayer may still elect to treat all interests in rental real estate, including the interest held in the partnership or S corporation, as a single activity [Reg. 1.469-9(h)(2)].Drawback: The biggest potential negative associated with making the election to aggregate rental real estate activities is the effect on the complete disposition rule under IRC Sec. 469(g). Any combined suspended passive losses allocable to the rental real estate activities will not be freed up until there is a disposition of substantially all of the combined interests [Reg. 1.469-4(g)]. If significant suspended passive losses are allocable to individual properties that are likely to be sold in the near future, the taxpayer should probably wait until the tax year after the dispositions to make the aggregation election to allow the losses to be deducted

Also, if the election is made and one or more of the rental real estate interests is a limited partner interest, the entire combined unit is subject to the much stricter material participation standards [see Prop. Reg. 1.469-5(e)(2)] that apply to limited partner interests. This may negate the expected benefits of making the election. However, this rule does not apply if the taxpayer's share of gross rental income from all the limited partner interests generates less than 10% of the gross rental income from all of the taxpayer's rental real estate interests for the year [Reg. 1.469-9(f)(2)].

The election is also inadvisable if the rental real estate properties are in the aggregate throwing off passive income. Passive income is always good, and combining the interests could result in the income becoming nonpassive. This may do no harm, but neither can it do any good.

\Finally, if rental real estate properties are in the aggregate throwing off PALs but those losses are being used to offset passive income from other sources, the election is unnecessary.

The aggregation election only makes sense when it converts passive losses that otherwise would be suspended because of insufficient passive income into nonpassive losses. If this happens, the effects of the disposition rule and the limited partner rule discussed previously must also be considered. Additionally, practitioners should consider that the election is effective at the first of the year for which it is made. Consequently, a taxpayer that is counting on a large passive gain from a property sale made early in the year could see that gain turn into nonpassive income if the election is made.

Liliya Patton · Answer

@Ashish Acharya

Thanks so much for taking the time to write that thorough answer.  Very helpful.  I think in our case the aggregation election would make sense -- we won’t have to worry about the disposition rule because we shouldn’t have suspended passive losses.  The aggregation election will make it easier for me to meet the 750/500 hours requirements under the real estate professional rules, and any rental real estate losses will presumably offset some of my husband’s W-2 income (rather than becoming suspended passive losses).

BTW, the third special rule in that section, 1.469-9(h)(3) states:  “If a pass-through entity owns a fifty-percent or greater interest in the capital, profits, or losses of another pass-through entity for a taxable year, each interest in rental real estate held by the lower-tier entity will be treated as a separate interest in rental real estate of the upper-tier entity, regardless of the lower-tier entity's grouping of activities under § 1.469-4(d)(5).”

Am I right that this has nothing to do with the aggregation election for real estate professional?  I.e., if you had tiered pass-through entities, a real estate profession could still treat the rental real estate interests held through the upper pass-through entity as a single real estate activity together with her other rental real estate activities?

This stuff is complicated . . . .