Self-rental, real estate professional, grouping election

Doing some tax planning for a client, and trying to get structures ironed out (and therefore bookkeeping) so 2019 will go smoothly.

The fact pattern is that client operates a property management business which is currently organized as an LLC (LLC "A"). He previously rented a building from a third party and used that as office and storage, but during 2018 purchased an identical building through a newly formed LLC (LLC "B"), and moved operations into this building. Individual is the 100% owner of both LLCs, and both LLCs are currently disregarded for tax purposes. LLC "B" will stay disregarded. LLC "A" may make an S or C Corp election in the future, but current and projected taxable income doesn't justify it yet.

Individual passes the two-prong test under IRC 469(c)(7)(B) and is considered a 'real estate professional' based on the property management business alone, but also has real estate agent income and rental real estate income on the side (though both are immaterial in comparison to the prop mgmt business).

My two main questions are (1) Will a self-rental of the building from LLC "B" to LLC "A" cause any negative tax consequences for taxpayer? (2) Can we group the LLC "A" activity and the rental real estate activity (and probably the RE agent activity) to mitigate negative self-rental consequences in this situation?

(1) is probably where I'm struggling the most. Some articles I've read suggest LLC "A" will be able to deduct the rent on Schedule C paid to LLC "B" as long as rent is ordinary and necessary for the LLC "A" and the rent/rental agreement is comparable to third-party rental agreements in the area. Conversely, some articles suggest the rent will not be deductible by LLC "A"

I know self rental income is considered non-passive, while self rental loss is considered passive. LLC "B" is expected to have self rental income continuously. LLC "A" will have a good amount of QIP.

I'm fairly confident we can group all activities (question 2) under Treas Reg 1.469-4 as they seem to pass the four "facts and circumstances" test, and because the real estate rental activity is insubstantial in relation to LLC "A".

Can't group a self-rental activity that produces net rental income with a passive activity that produces a net rental loss.
See this thread: viewtopic.php?f=8&t=12829
"QIP"? Quality Improvement Project/Plan/Program? Quality Intellectual Property?

Hey Dave,

Thanks for your response. I wasn't necessarily thinking of grouping the self-rental. Taxpayer has the following activities:

(1)Operating Business (LLC "A")
(2)Self-rental (LLC "B")
(3)Real estate agent income
(4)Residential real estate rental leased to third party

I was considering grouping 1, 3, and 4 under Treas Reg 1.469-4, sorry that wasn't clear. I expect the self-rental to throw off net taxable income, which would be non-passive. Grouping would allow all net taxable losses from the other activities to offset the self-rental as they would be non-passive?

"QIP"? Quality Improvement Project/Plan/Program? Quality Intellectual Property?

Sorry, Qualified Improvement Property under the TCJA.

How can the real estate rental activity be insubstantial and the taxpayer still satisfy the material participation test of Reg 1.469-5T? Seems like these two are contradictory.

I was considering grouping 1, 3, and 4 under Treas Reg 1.469-4, sorry that wasn't clear. I expect the self-rental to throw off net taxable income, which would be non-passive. Grouping would allow all net taxable losses from the other activities to offset the self-rental as they would be non-passive?

I don’t understand. Why would grouping allow them to be nonpassive?

It seems to me that if the client qualifies as a real estate professional and satisfies the material participation test for the rental activity (4), then all of the activities are treated as nonpassive and you don't have to worry about any grouping issues.

"Individual is the 100% owner of both LLCs [A and B], and both LLCs are currently disregarded for tax purposes," you say in the OP.
Based on that, I would opine that for income tax purposes any payment of "rent" from the one to the other is no more than "moving money from the right pocket to the left" and consequently is neither taxable nor deductible as rent. There's a court case from a few years ago that agrees with me.

How can the real estate rental activity be insubstantial and the taxpayer still satisfy the material participation test of Reg 1.469-5T? Seems like these two are contradictory.

Insubstantial in comparison to the operating business as required by 1.469-4(d)(1)(i)(A)? However re-reading that reg it wouldn't seem to matter in this situation as the taxpayer satisfies 1.469-4(d)(1)(i)(C) just fine. 1.469-5T(a)(2) is satisfied by taxpayer:

The individual's participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

I don’t understand. Why would grouping allow them to be nonpassive?

It seems to me that if the client qualifies as a real estate professional and satisfies the material participation test for the rental activity (4), then all of the activities are treated as nonpassive and you don't have to worry about any grouping issues.

You're right, the grouping election isn't necessary as the taxpayer is a real estate professional and satisfies material participation under 1.469-5T

I was attempting to make sure I had a good reason to treat the rental activity (4) taxable loss as non-passive.

Agree with Spell Czech. The reference is sec. 162(a)(3):

(a) IN GENERAL.--There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including—
* * *
(3) rentals or other payments required to be made as a condition to the continued use or possession, for purposes of the trade or business, of property to which the taxpayer has not taken or is not taking title or in which he has no equity.

You’re somewhat lost. What you describe is a single-member LLC owned by individual client (LLC A, the property management business) using a building in its operations (a building owned by LLC B, which is also a single member LLC owned by individual client). No rent should be paid, since you can’t pay rent to yourself. On the Schedule C for the property management business, simply put the building on the depreciation schedule. The depreciation expense, along with all other operating expenses of the building, will be deductible on said Schedule C. No different than a computer owned by the business.

Both entities are disregarded for income tax purposes and are owned by the same person. Transactions between them are a big nothing.

All falls into place, thanks Jeff. That makes a lot more sense and clarifies. I guess taxpayer could execute a lease and pay rent between LLCs, but this would be for legal purposes only. For tax we'd look at how the building is used if both entities are disregarded.

Self-rental may come into play if LLC A (operating LLC) wasn't disregarded and taxpayer has material participation. Got it.