The Real Estate Investment Every Entrepreneur Should Consider

I’m not a real estate investment fanatic. I mean, sure, I think real estate investment probably belongs in most people’s portfolios. But you can do that efficiently by holding a REIT index mutual fund or EFT.

Some folks can also prudently buy the home or apartment where they reside. But after those obvious options? I’m pretty agnostic. Except, that is, for the real estate investment every entrepreneur should consider: Self-rental property your business occupies.

Why Self-rental Property is So Attractive to Entrepreneurs

Self-rental property works great for entrepreneurs for a simple reason. As long as they follow the rules, they can pretty effectively unlock depreciation deductions that normally other real estate investors can’t unlock. Or unlock without spending tons of time or doing lots of fiddling.

A real estate professional by the way can unlock depreciation deductions. But to do that, she or he will need to spend more than 750 hours and more than 50 percent of their time working in a real estate trade or business. They will also need to materially participate in the properties they own if they want to deduct the depreciation—and this can be problematic.

And by the way? Short-term-rental investors? Yes, they can get giant deductions on their return too. And they may be able to materially participate with very modest hours. But they also need to manage the average rental interval of guests. Because in order to qualify as a short-term-rental investor? Your average rental interval needs to equal 7 days or less.

A self-rental property, however? Easy for entrepreneurs if they do it right.

The Self-rental Property Depreciation Deduction Estimator

Take a peek at the simple JavaScript Calculator below. It shows the depreciation deductions you can probably get from a owner-occupied commercial property that cost $1,000,000. The calculator uses the bonus depreciation numbers for 2024 and assumes a cost segregation engineer has broken down the price into real property and personal property.

To summarize, once you click the Calculate button, the Self-rental Property Depreciation Deduction Estimator calculates depreciation deductions for the first year through seventh years. These calculations assume a $1,000,000 price broken down into 25% land, 15% five -year property, 30% fifteen-year property, 0% 27.5-year property, and 55% 39-year property. And the assumption is the bonus depreciation percentage equals 60%. Which is the right percentage for 2024. But what’s unique here? As compared to most real etate investors who will not get to use those gian depreciation deductions? An entrepreneur very probably will.

Tip: Replace the percentages, or decimal values, for your potential real estate investment to estimate actual depreciation you might deduct on your return. And then click Calculate again.

Note: The seventh year’s depreciation is also roughly the depreciation deduction for years that follow the seventh year.

The Usual Problems with Real Estate Depreciation and Other Deductions

The problem with those big deductions however? In many, perhaps most cases, you can’t actually use them. Section 469 of the Internal Revenue Code limits your deductions on a passive investment like real estate to the income you earn from other passive investments. (This is the usual rule for real estate investments, by the way.)

Something special happens with self-rental property that the entrepreneur correctly sets up, however. First, if the entrepreneur groups the rental property with the operating trade or business? That grouping causes Section 469 rules to see the grouped rental property and active trade or business as not a real estate rental activity.

The second thing to happen? The entrepreneur looks at the hours she or she spends on both the rental property and the other active trade or business to determine whether they materially participate. If they spend more than 500 hours on the grouped activities? Bingo.

The First Requirement for Grouping the Rental with the Active Trade or Business

You have two requirements to get a grouping to work. First, the ownership of the rental property needs to perfectly match the ownership of the other operating trade or business. For example, if two shareholders own 60 percent and 40 percent of say an engineering firm? They would also need to own those same percentages—so 60 percent and 40 percent—of the building the engineering firm rents.

Note: You typically would put the real estate into one entity, like a limited liability company. And treat that entity as a partnership. And then the other operating trade or business might be a different partnership. Or a corporation.

The Second Requirement for Grouping

You need to make the grouping in the first year you own the property or operate the trade or business. For example, if this year, you buy a building to house the engineering firm you and your partner have operated for decades? You need to make the grouping election on this year’s tax return.

Note: Not all grouping and aggregation elections need to be made in the first year an activity or trade or business exists. With Section 469 grouping elections like a self-rental, however, the decision not to group the first year is treated as a default grouping. And then the problem that creates? You can’t regroup later on except in special circumstances. And then only with the Internal Revenue Service’s permission.

A Predictable Caveat

Let me end with a predictable caution. One you really don’t even need me to give. (Sorry. But accountants have pretty conservative, compulsive personalties.)

The tax deductions you generate by buying a building and renting it to your business? Very high impact. You may be able to in effect save hundreds of thousands of dollars pretax by using this gambit. (In comparison, remember something like a Section 401(k) plan in the absolutely best case scenario maybe lets you save $70,000-ish of pre-tax money.)

But the tax savings? Not so good an entrepreneur can ignore the return on investment. Thus, we want to treat a prospective real estate investment that same way we’d treat any other business investment. We probably want to calculate the anticipated return on investment. Consider whether and how we can safely use borrowed funds for some of the purchase price. Stuff like that.