Passive Activity Loss Rules, Cost Segs, and the IRC Section 469 Election, OH MY!

For many business owners, the building where they primarily conduct their business is often held in a separate LLC for asset protection and legal liability reasons. This is known as a self-rental, i.e. renting the building to oneself. From a tax perspective, any losses on the self-rental are going to be passive and any income is going to be non-passive. Okay – in English please? If there is a loss on the self-rental, it can only be netted against any other passive losses; it generally won’t be able to be netted against income from the main business, unless a special election is made, which will be discussed below.

Under regular operations, it’s not usually a problem that the self-rental produces passive losses. Usually, the main business pays rent to the self-rental, there’s some additional expenses, and it maybe produces a small loss. Now say the business purchased a new building and is going to do extensive renovations prior to moving in. What’s the big deal here? Enter the cost segregation study.

A cost segregation study allows companies and individuals who have constructed, purchased, expanded, or remodeled a building to accelerate depreciation deductions to the current year. Say a business owner purchases a building for $6 million. Without a cost segregation study, that $6 million building would be depreciated over a period of 39 years. A cost segregation study will determine if there are components of the building that can be depreciated over a shorter useful life of 20 years or less – thus allowing for bonus depreciation or immediate write-off in the current year. Let’s say the cost segregation study identifies an additional $2 million of current year depreciation deductions and net income in the LLC before depreciation is only $500k. What’s the issue? Remember those passive activity loss rules above? Well, the $2 million of depreciation deductions (passive at the self-rental) can’t be netted against the $500k of business income (active income). Uh oh, but wait…

Enter the grouping election under IRC Section 469. Regs. §1.469-4(c)(1) provides a facts and circumstances test that would allow the taxpayer to group together the self-rental and regular business as one “activity.” By doing this, those $2 million of depreciation deductions discussed above could directly offset the $500k of business income and thus wiping out the current year tax liability. The factors to consider when making this determination are:

• Similarities and differences in type of trades or businesses
• The extent of common control
• The extent of common ownership
• Geographical local
• Interdependencies between the activities

A rental activity cannot be grouped with another trade or business activity unless they have the same proportionate ownership interest or either activity is insubstantial when compared to the other activity. Usually, a self-rental will meet one of these qualifications and can make this election.

To make the election, a statement must be attached to the tax return and filed by the due date, including extensions, for the year the taxpayer wishes to make the election. It can be made by C corps, S Corps, partnerships, individuals, estates, and trusts. Once the election has been made, it must remain consistent from year to year, unless:

• It’s been determined a grouping was inappropriate,
• A material change in facts and circumstances necessitates a change in grouping, or
• The IRS finds that a group doesn’t constitute an appropriate economic unit.

Cost segregation studies can be of great value to taxpayers, but taxpayers should make sure they understand their ownership structure and plan to make this important election, if necessary.

For more information about McKonly & Asbury’s Architecture, Engineering, and Construction (AEC) experience, visit the AEC Industry Page and don’t hesitate to contact a member of the AEC team.

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