Posted by: Lacey Strachan | October 27, 2017


A taxpayer’s trade or business undertakings can be combined to form an “activity” for purposes of the material participation rules if the undertakings “form an appropriate economic unit for measuring gain or loss under the passive activity rules,” considering all relevant facts and circumstances.  Taxpayers have the freedom to group their undertakings using any reasonable method; however, there is an exception to the “appropriate economic unit” grouping rules for rental activities – in general, rental activities may not be grouped with a non-rental trade or business.[i]  Rental activities are by definition passive, and the income and losses from the activity generally cannot become active by considering them as part of a greater activity involving the conduct of an active trade or business.

There is an additional rule in the regulations under Section 469 that applies to the treatment of rental activities: Treasury Regulation Section 1.469-4, which sets forth the grouping rules for purposes of Section 469 for determining the scope of an “activity” for purposes of Section 469. Separate from the exception to the per se passive rule for real estate professionals in Section 469(c)(7) and separate from the exceptions to the definition of “rental activity” in Treasury Regulation Section 1.469-1T(e)(3), Treasury Regulation Section 1.469-4(d)(1)(i) provides, in pertinent part, that a rental activity may be grouped with active trade or business activities if they constitute an appropriate economic unit and the rental activity is insubstantial in relation to the trade or business activity.[ii]

This grouping rule effectively provides an additional exception to the definition of rental real estate, as recognized in Treasury Regulation Section 1.469-9(b)(3) (definition of “Rental real estate” for purpose of Treasury Regulation Section 1.469-9: “Rules for certain rental real estate activities”), which provides: “[A]ny rental real estate that the taxpayer grouped with a trade or business activity under §1.469-4(d)(1)(i)(A) … is not an interest in rental real estate for purposes of this section.”

However, there has been little guidance that taxpayers can rely on for determining whether a rental activity can be combined with another trade or business because it is insubstantial in relation to the rest of the trade or business. In an earlier version of the regulations (Treas. Reg. § 1.469-4T), the IRS set forth a quantitative test to determine whether a rental activity is insubstantial in relation to a non-passive activity.  The regulation explained that the rule that rental operations and nonrental operations must generally be treated as separate undertakings does not apply if, in pertinent part, “more than 80 percent of the income of the undertaking determined under the basic rule is attributable to one class of operations (i.e., rental or nonrental).”[iii]

Although the regulations do not provide an example of a situation where a rental activity was allowed to be grouped with a non-passive activity pursuant to this rule, an example provided states:

“Attorney D is a sole practitioner in town X. D also wholly owns residential real estate in town X that D rents to third parties. D’s law practice is a trade or business activity within the meaning of paragraph (b)(1) of this section. The residential real estate is a rental activity within the meaning of §1.469-1T(e)(3) and is insubstantial in relation to D’s law practice. Under the facts and circumstances, the law practice and the residential real estate do not constitute an appropriate economic unit under paragraph (c) of this section. Therefore, D may not treat the law practice and the residential real estate as a single activity.”[iv]

In this example, the IRS acknowledges an example of where a real estate rental activity is insubstantial in relation to another trade or business, but in this example, the rental activity and the trade or business do not provide an appropriate economic unit because they are unrelated businesses. This suggests that these activities could be grouped if the activities were related, such as both involving aspects of a larger real estate business.

We have found only a few cases that have addressed this argument. In each case, the courts have found a rental activity to be insubstantial to a non-rental activity, or vice versa, based on the particular facts of the case.  Courts have considered both qualitative and quantitative factors in determining whether a rental activity is insubstantial.[v]  In one case, the qualitative factors included there being (1) a close operating relationship, (2) intertwined operations, and (3) a shared accounting system, among other factors.  For the quantitative analysis, the court applied an 80/20 test that was part of the old regulations on this topic – under this test, an activity is insubstantial if the gross income from the activity is less than 20% of the total gross income. The relative asset values of the activities will also be considered.[vi]

Most recently, a district court held in Stanley v. United States, 96 F. Supp. 2d 850 (W.D. Ark. 2015), that a taxpayer appropriately grouped together his rental and non-rental activities pursuant to Treas. Reg. § 1.469-4, rejecting the Government’s argument that the rule under Treasury Regulation § 1.469-9(e)(3)(i), which sets forth the rules for rental real estate, prohibits all grouping of non-passive activities with rental activities, notwithstanding the provisions in Treasury Regulation Section 1.469-4 that allow rental activities to be grouped with non-passive activities if the rental activity is insubstantial.

In Candelaria v. United States, 518 F. Supp. 2d 852, (W.D. Tex. 2007), the court found a taxpayer’s losses from a rental activity to be non-passive, because the rental activity was insubstantial in relation to another of the taxpayer’s business activities for the tax year at issue.  The court noted that the trade or business was “a rapidly expanding enterprise with multiple employees, three business locations and a provider of various services to the community at large,” while the rental activity was a “company with no employees, one client, and a gross income and net income that each represent less than 20 percent of the combined totals of the two companies.[vii]  Considering these facts and additional considerations, the “Court’s realistic economic sense of the situation is that CEL’s rental activity is insubstantial in relation to DIS’s business activity for the year 2000.”

This issue was also addressed in a Summary Opinion, Schumacher v. Commissioner, T.C. Summary Opinion 2003-96.  In finding that a leasing activity was insubstantial in relation to a non-rental activity, the court reasoned:

“We find that, in ascertaining whether the leasing activity was insubstantial in relation to the PFC activity, the most significant fact in this case is that petitioner created and operated the leasing activity solely for PFC’s benefit. In furtherance of this goal, petitioner spent very little time conducting the affairs of the leasing activity in comparison with the very substantial amount of time and effort expended by petitioner in carrying on PFC’s business. The leasing activity was intended to, and in fact did, provide a service solely to PFC. Its purpose was to enhance PFC’s ability to generate business, maintain PFC’s viability as an ongoing concern, and possibly enable PFC to become profitable in the future, not to provide an income stream independently from PFC. Consistent with this purpose, the leasing activity had gross receipts of $ 9,500 in 1998 and $ 34,940 in 1999, compared to PFC’s gross receipts and other income of $ 804,492 and $ 1,092,295 in each respective year.”[viii]

Finally, in an earlier case, Glick v. U.S., 96 F. Supp. 2d 850 (S.D. Ind. 2000), the district court addressed a situation involving rental real estate; however, the court was presented with the reverse situation, where an active trade or business was turned passive, thereby allowing it to offset passive losses. Glick v. United States involved an apartment management corporation which managed a series of apartments on behalf of over a hundred partnerships.  The court noted that they were an integrated business unit with operational tie-ins, such as the use of a single accounting system.  Where there  was 116 limited partnerships that rent properties with a single C corporation that manages them, the court found the that the management company was insubstantial relative to the rest of the rental business.

Although not explicitly identified in the Code or regulations as an exception to the per se passive rules applicable to rental real estate, the above cases demonstrate that if a taxpayer can establish that the rental real estate activity is insubstantial in relation to another of the taxpayer’s businesses and that together they make an appropriate economic unit, the taxpayer may be able to convert a passive rental activity into a part of an active trade or business that is not subject to the loss limitation rules of Section 469.

LACEY STRACHAN – For more information please contact Lacey Strachan at Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at

[i] Treas. Reg. § 1.469-4(d)(1)(i); Treas. Reg. § 1.469-9(e)(3)(i).

[ii] Treas. Reg. § 1.469-4(d)(1)(A). § 1.469-4(d)(1)(B) also allows grouping where a trade or business activity is insubstantial in relation to the rental activity and § 1.469-4(d)(1)(C) allows grouping where each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.”

[iii] Treas. Reg. 1.469-4T(a)(3)(iv).

[iv] Treas. Reg. 1.469-4(d)(1)(ii)(Example 2).

[v] Note the distinction between the term “insubstantial” as it is used in this section, and “incidental” as it is used in the exception to the definition of rental activity in Treasury Regulation Section Treas. Reg. §

[vi] Candelaria v. United States, 518 F. Supp. 2d 852, 858-859 (W.D. Tex. 2007) (explaining that although Temporary Treasury Regulation § 1.469-4T is no longer in place and there is no equivalent bright line test in the current regulations, the current regulations call for a facts and circumstances analysis, under which it will take into consideration the quantitative guidelines from the old regulation).

[vii] Id. at 859-860.

[viii] Schumacher v. Commissioner, T.C. Summary Opinion 2003-96.

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