Many business owners own both their operating business and the building that business operates in. The usual setup is simple: the business pays rent to a building LLC, the LLC takes depreciation, and everyone assumes they’re getting the full benefit of the structure.
The issue is that the passive activity rules treat self-rentals differently, and the default treatment often blocks you from using losses when you need them most. This becomes especially noticeable in a cost segregation year. The fix is the grouping election, but most owners are never shown how it works or why it matters.
Below is a simple, real-number example so you can see exactly where self-rentals break down and how grouping solves it.
A Simple Example
You own:
- A CPA practice (Schedule C)
- The building it occupies (owned in an LLC)
For the year:
- CPA profit: $200,000
- Rent paid from the practice to the LLC: $36,000
- Cost segregation bonus depreciation: $(450,000)
- Spouse’s W-2 wages: $150,000
- You materially participate in the CPA practice
We’ll compare two outcomes:
- Default self-rental treatment
- Grouping the building and business into one activity
Scenario 1: Default Self-Rental Treatment
The self-rental regulation says that only net rental income is recharacterized as non-passive. “Net” means income minus deductions.
First, calculate the rental LLC’s results:
- Rental income: $36,000
- Bonus depreciation: $(450,000)
- Net rental result: $(414,000)
Because the rental nets to a loss, there is no net rental income, so nothing is recharacterized as non-passive.
What you end up with is:
- Non-passive income from the rental: $0
- Passive loss: $(414,000), suspended
And that passive loss cannot be used this year to offset:
- Your $200,000 of CPA income
- Your spouse’s $150,000 W-2 income
You still get the depreciation; it wipes out the rent entirely. But the remainder drops into the passive bucket and gets stuck there until you generate passive income or dispose of the property.
This is where most people assume they’ve “lost” a benefit, when really it’s just locked away.
Scenario 2: Grouping the Building With the CPA Practice
If the building exists solely to support the operating business, ownership matches, and you are effectively the only tenant, the IRS allows both activities to be treated as one combined activity. This is the grouping election under Reg. 1.469-4.
When grouped, the building and the CPA practice become one non-passive activity.
Now combine the numbers:
- CPA profit: $200,000
- Rent (still part of the activity’s income): $36,000
- Cost seg bonus depreciation: $(450,000)
Combined activity result: $(214,000)$ non-passive loss
Because the entire activity is non-passive, you can use that loss against all of your non-passive income.
Your only remaining non-passive income for the year is your spouse’s W-2:
- W-2 income: $150,000
- Loss applied: $(150,000)
Remaining: $(64,000)$ non-passive loss, carried forward (subject to the §461(l) business loss limitation rules)
And importantly:
- The rent portion is still not subject to self-employment tax
Grouping doesn’t change how SE tax works. It only changes how income and losses are classified under the passive activity rules.
Side-by-Side Summary
Without Grouping (Self-Rental)
- $36K rent is fully wiped out by depreciation
- Remaining $(414K)$ is a passive loss
- Cannot offset CPA income
- Cannot offset W-2 wages
- Passive loss is suspended
With Grouping (One Activity)
- Building + business = one non-passive activity
- Net loss = $(214K)$ non-passive
- Can offset W-2 income and business income in the same year
- Remaining $(64K)$ carried forward as non-passive
- SE tax treatment unchanged
Why This Matters
Self-rental rules don’t stop you from deducting depreciation. They simply classify the leftover loss as passive, and passive losses can’t offset W-2 wages or business income.
Grouping removes the passive bucket entirely for this activity and treats the whole thing as part of the business you already materially participate in.
For owner-operators—especially in a cost segregation year—this can be the difference between carrying a large loss forward for years or using it today to reduce your tax bill dramatically.
If you own your building, are the only tenant, and the ownership structure lines up, the grouping election is often worth evaluating every single time.
