This article is co-authored by Paul Ellis and Bob Yates who both lead our dedicated Real Estate Tax Consulting Group.

For real estate investors and small business owners, understanding the relationship between related rental real estate and business activities is crucial for effective tax planning. One of the most overlooked, yet impactful areas of the tax code, is the self-rental rule under Internal Revenue Code (IRC) Section 469, and the ability to overcome its limitations through grouping rules under Treasury Regulation §1.469-4(d).

Explore how these rules work, including the grouping of rental and non-rental activities, the pros and cons of doing so and who stands to benefit most from this strategy.

Understanding IRC Section 469 and the Self-Rental Rule

IRC Section 469 governs passive activity losses, a set of provisions designed to prevent taxpayers from using passive losses (commonly from rental real estate) to offset active income like wages or business profits. Under Section 469, rental activities are generally deemed passive—even if the taxpayer actively manages the property.

However, an exception exists for self-rental scenarios, where a taxpayer rents property they own separately to a business they materially participate in—often one they also own or control. In these situations, a special recharacterization rule applies under Reg. §1.469-2(f)(6): Net income from the rental of property to a trade or business activity in which the taxpayer materially participates is treated as non-passive income—but any net losses remain passive.

This imbalance creates a disadvantageous tax outcome. Taxpayers are taxed on rental income as if it were active but are not allowed to deduct losses unless they have other passive income to offset.

How Grouping Under §1.469-4(d) is Advantageous 

Treasury Regulation §1.469-4 sets out the rules for grouping activities to determine material participation and classify income or loss. Specifically, this section provides a critical exception for grouping rental and nonrental activities when certain conditions are met.

There are three primary situations where grouping is allowed:

1. The rental activity is insubstantial in relation to the business activity.
2. The business activity is insubstantial in relation to the rental activity.
3. The rental activity is integral to the business activity and both are commonly controlled.

The third exception—common control—is the most frequently used. To qualify for self-rental grouping, the following must generally be true:

• Common ownership: The same individuals or entities must own both the rental property and the operating business, and in the same proportionate ownership interests. The combined ownership of all active participants must equal or exceed 50% of both the rental entity and the business entity.
• Related use: The operating business must actively use the building or property as its primary location or a significant part of its operations.
• Appropriate economic unit: The activities must constitute an "appropriate economic unit" based on all relevant facts and circumstances, which may include factors like similarities in types of businesses, common control, common ownership, geographical location, and interdependence among the activities.

By making this grouping election, the rental and the operating business are treated as one activity. If the taxpayer materially participates in the business, then the entire combined activity (including the rental) is considered non-passive.

Cost Segregation as a Companion Strategy

Cost segregation is a powerful tax strategy that pairs exceptionally well with self-rental planning. By accelerating depreciation on eligible components of a building, a cost segregation study can generate substantial upfront deductions. When paired with a proper grouping election under Treasury Regulation §1.469-4(d), these depreciation-based losses are no longer locked as passive, but can instead offset active income from the operating business.

This strategy is even more compelling with the reinstatement of 100% bonus depreciation, for assets placed in service after Jan. 19, 2025, which allows taxpayers to immediately expense qualified property with a recovery period of 20 years or less. The synergy of 100% bonus depreciation, cost segregation and self-rental grouping offers one of the most effective ways to rapidly reduce taxable income for business owners who also hold real estate.

Pros and Cons of Grouping

While there are many benefits of grouping under Treasury Regulation §1.469-4(d), there are some key areas of caution to keep in mind. 

On the upside, grouping can help: 

• Avoid imbalance of the self-rental rule: Grouping eliminates the mismatch where income is taxed but losses are nondeductible.
• Unlock deductions: Rental losses (e.g., from depreciation) can offset active income if grouped with a materially participated business.
• Consolidate activity testing: Material participation is tested at the group level, simplifying compliance for closely held entities.
• Create a flexible planning tool: This is useful for taxpayers who own both real estate and an operating business in tandem.

However, it’s important to be aware of issues such as: 

• Binding election: Once made, the grouping election is binding unless there’s a material change in facts and circumstances.
• Disclosure required: Taxpayers must file a written disclosure (typically on a statement attached to the tax return) to notify the IRS of the grouping.
• Audit exposure: Improper or undocumented groupings may trigger IRS scrutiny or recharacterization.
• Loss of flexibility: Grouping may limit future strategic separation of businesses for legal, financial or estate planning reasons.

Who Benefits Most?

This grouping strategy is ideal for:

• Owners of closely held businesses who separately own the real estate used by the business and intend to hold the real estate for an extended period of time.
• Taxpayers with high K-1 or Schedule C income who want to unlock real estate losses for offset purposes.
• Sole proprietors, members or shareholders looking to streamline passive activity testing and maximize deductions.

Final Thoughts

The self-rental rule under Section 469 is a frequent tax planning oversight for closely held business owners who also own their real estate. While the rule can create an unfavorable position—forcing taxpayers to pay taxes on income but disallowing losses— Treasury Regulation §1.469-4(d) provides an effective solution.

By carefully grouping the rental and business activities, eligible taxpayers can treat the combined operation as non-passive, unlocking valuable tax deductions and simplifying their reporting. When paired with cost segregation and 100% bonus depreciation, this approach can help reduce current tax liability while maintaining long-term strategic flexibility. However, proper planning, documentation and disclosure are essential. When executed correctly, grouping can turn a costly mismatch into a strategic advantage.