You Own Commercial Real Estate. You May Have More Tax Planning Tools Than You Think.

How grouping elections, passive activity rules, and private real estate investments may fit into a broader planning strategy. 

MLG has a simple mission when it comes to private real estate investing – we seek to produce attractive risk-adjusted and after-tax returns for our investors. Tax considerations are often an important part of an investor’s overall financial picture. For many commercial real estate owners and high-income earners, understanding how different investments are taxed can be just as important as evaluating potential returns. Part of the reason we love investing in real estate is because it is an incredibly tax-advantaged asset class. Of course, the first objective is always to invest in quality real estate through the right structure, but thoughtful tax planning can be an important part of the overall value proposition and a meaningful contributor to after-tax returns.

We’ve written at length about the benefits of real estate investing for passive investors, and those benefits can be incredibly powerful, especially when measured over a long period of time with consistent reinvestment. For certain active real estate investors, however, the math changes in a meaningful way. If you are considered a Real Estate Professional for tax purposes and materially participate in your rental real estate, you could potentially deduct losses sooner.  While the general rule is to determine your participation level for each activity separately, one tax planning concept worth understanding is a grouping election, which may allow qualifying rental real estate activities to be treated as a single activity for certain tax purposes. This can potentially allow rental losses that might otherwise be treated as passive to be considered nonpassive.

While the rules are nuanced and highly dependent on an investor’s individual circumstances, a grouping election can become an important part of the broader tax planning discussion for some commercial real estate owners.

Key Takeaways

• A grouping election may allow qualifying rental real estate activities to be treated as a single activity for certain tax purposes.
• Real Estate Professional Status and material participation are separate analyses.
• Depreciation-related tax-loss allocations may provide planning opportunities, subject to applicable limitations.
• Investors should consult their CPA and tax counsel before making any tax-related decisions.

Real Estate Professional Status and Material Participation

To achieve Real Estate Professional Status (REPS) for tax purposes, there are two tests that must be met.

1. 50% Test – the taxpayer must spend over 50% of their working hours across all trades/businesses in real property activities where they materially participate
2. 750 Hour Test – the taxpayer must spend more than 750 hours in a tax year in real property businesses on qualifying activities.

In addition to achieving REPS, the taxpayer must determine whether they materially participate in each rental activity. The IRS provides several tests for determining material participation, but one common test is whether the taxpayer spends more than 500 hours during the year participating in that rental activity. Without an applicable election, that determination is generally made activity by activity.

It’s critical that an investor consult with their CPA and tax professional around how these tests apply to their situation and understand the nuances around each of the tests. For those that do qualify, however, the impact can be very powerful.

What Is a Grouping Election?

For many owners, the material participation analysis is performed on a property-by-property basis. However, under IRC Section 469(c)(7)(A), real estate professionals may be able to make a grouping election that treats qualifying rental real estate activities as a single activity for material participation purposes. In the right circumstances, this can change how an investor’s participation is evaluated across their portfolio. While a grouping election does not create a tax deduction or guarantee a particular tax outcome, it can be a valuable planning tool when evaluated alongside a taxpayer’s broader real estate holdings.

How Depreciation Creates Tax-Loss Allocations

One of the primary tax benefits that we talk about at MLG centers around depreciation. By definition, depreciation is a non-cash expense that all asset owners realize in the form of a gradual decrease in the useful life of their asset over time. When someone buys an apartment building, for example, the IRS dictates that the asset has a useful life of 27.5 years. So, each year on their tax return, an investor can take 1/27.5 of their depreciable basis as an expense that lowers their taxable income. At MLG, when we acquire a multifamily property, we hire an engineer to perform a cost segregation study. A cost segregation study breaks down the property into its component parts. Those component parts include appliances, parking lots, fixtures, and everything that is actually included in the acquisition of the property. The component parts of the property typically have shorter depreciation life than the structure of the asset itself, and certain property qualifies for bonus depreciation, where 100% of the asset value can be taken as a deduction in the first year it is placed into service. The benefit of all this is that, especially in the first year of an investment, assets can produce significant paper losses that can be passed back through to investors if the investment is held in an appropriate pass-through entity, like an LLC taxed as a partnership. For those that invest in MLG’s funds (which are structured as LLCs taxed as partnerships), investors may receive depreciation-related tax-loss allocations reflected on their K-1, although the amount will vary based on the underlying investments, tax rules, and individual circumstances.

Why It Matters

For many passive investors, tax losses are generally used to offset passive income. If those losses cannot be used immediately, they may be carried forward and potentially used in future years, subject to applicable tax rules. In some situations, investors may also be able to unlock suspended passive losses through specific planning strategies. Readers interested in learning more can explore our article on the Passive Loss Release Strategy.

For real estate professionals who materially participate in rental real estate activities, however, losses may be used to offset active income, including W-2 income, assuming all applicable IRS requirements are satisfied.

Putting the Strategy Into Context

As a hypothetical example, let’s say an investor owns and operates a 50-unit multifamily property with no debt, and let’s say they’ve owned the property for a long time, so they have no remaining tax basis for depreciation. Let’s also say the investor has REPS and materially participates in this activity.  If the property is worth $100k/unit at a 6% cap rate, the investor may have taxable income from the property of $300,000/year. This income would be taxed at ordinary income tax rates and the investor’s after-tax cash flow could be reduced by 30-50% depending on their tax rate. If that same investor decided to make a $500,000 investment in MLG Fund VII and made the grouping election under IRC Section 469(c)(7)(A), they could potentially receive a $300,000 loss in Year 1 and entirely defer their taxable income.

Many commercial real estate owners find themselves in a similar position. They may own high-quality assets that have appreciated over time and continue to generate strong cash flow, but they now face increasing taxable income as depreciation benefits begin to diminish. At the same time, they may have little interest in acquiring and managing additional properties simply to address a tax concern.

In these situations, some owners choose to evaluate whether an additional private real estate investment could complement their existing portfolio while potentially creating new tax planning considerations. Every situation is different, which is why investors should work closely with their CPA and tax counsel to evaluate the opportunities and trade-offs involved.

If you’re interested in learning more about MLG Fund VII and how a private real estate investment may fit within your broader portfolio strategy, we’d be happy to start the conversation.

Frequently Asked Questions

Disclaimer 

This blog and associated materials are being presented for informational purposes only and are not an offer to sell interests in a security. A private real estate investment is subject to risks and uncertainty many of which are not outlined herein including, without limitation, risks involved in the real estate industry such as market, operational, interest rate, occupancy, inflationary, natural disasters, capitalization rate, regulatory, tax and other risks which may or may not be able to be identified at this time and may result in actual results differing from expected. Private investments are highly speculative, illiquid, may involve a complete loss of capital, and are not suitable for all investors. Prospective investors should conduct their own due diligence and are encouraged to consult with a financial advisor, attorney, accountant, and any other professional that can help them to understand and assess the risks associated with any investment opportunity.

This blog contemplates complex tax concepts that each recipient should review with their professional tax advisor for further guidance. This presentation should not be considered tax advice and each recipient should consult with their tax advisor regarding the content, definitions and assumptions outlined in this blog.

This blog contains hypothetical examples and financial illustrations based on certain assumptions described herein. These assumptions have been made in good faith for illustrative purposes only. Actual events and results will differ, potentially to a material extent, due to factors including tax characterization, timing, investor‑specific circumstances, and other variables beyond MLG’s knowledge or control. The examples do not reflect the experience of any actual investor and are not indicative of future results. There can be no assurance that similar investment opportunities, tax outcomes, or results will be achieved.

Securities offered through North Capital Private Securities, Member FINRA/SIPC. Its Form CRS may be found here and its BrokerCheck profile may be found here. NCPS does not make investment recommendations and no communication, through this website or in any other medium, should be construed as a recommendation for any security offered on or off this investment platform.

Advisory services offered through MLG Fund Manager LLC, an investment adviser registered with U.S. Securities & Exchange Commission.