The short answer to the question above is yes.
But not automatically, and not without the right structure in place first.
This is a common question we hear from business owners who own or are buying the building their company operates in. The assumption is that owning the building means the depreciation flows straight to the business tax return. In most cases, it doesn’t without a specific election that has to be made before the tax year closes.
Understanding why comes down to how the IRS categorizes income, and why depreciation from a building often ends up somewhere it can’t offset the income you’re actually trying to reduce.
Why Real Estate Depreciation Doesn’t Automatically Offset Business Income
The IRS doesn’t let all income and deductions mix freely. For our purposes, there are two categories that matter.
Active income is what your operating business generates — the dental practice, the gym, the franchise, the medical practice. If you’re running it, that income is active.
Passive income is what your building generates. By law, rental real estate is always treated as passive — regardless of how involved you are in managing it. It doesn’t matter that you own both the building and the business inside it. The moment rent is involved, the building’s income and losses default to passive.
Passive losses can only offset passive income and cannot reduce your active business income.
So when a cost segregation study generates $300,000 of first-year depreciation from your building, and your operating company produces $400,000 of profit — those two numbers don’t automatically cancel each other out. The depreciation is passive. The business income is active. The IRS keeps them in separate buckets.
Those passive losses get suspended and carry forward indefinitely, waiting until you either have passive income to absorb them or sell the property.
How the Grouping Election Allows Real Estate Losses to Offset Business Income
The tax code does offer a direct solution. It’s called the grouping election, and it’s found in Treasury Regulation 1.469-4.
The grouping election allows you to treat your operating business and the building it operates from as a single economic activity for tax purposes. When those activities are grouped and you materially participate in the combined operation, the rental losses stop being passive. They become non-passive, meaning they can offset your active business income.
A common point of confusion is how ownership needs to be structured.
The business and the real estate do not have to be owned by the same legal entity. In fact, they often aren’t. A very common structure looks like this:
- Operating business in LLC #1 (taxed as an S-corp or partnership)
- Building owned by LLC #2
- LLC #2 leases the building to LLC #1
Even though those are separate entities, the IRS still allows grouping as long as the ownership behind them is substantially the same and the activities function as one integrated business operation.
For example:
- A dentist owns 80% of both the practice entity and the real estate entity
- A gym owner owns both the operating company and the property LLC
- A franchise operator owns the building through one partnership and the operating entity through another
In these situations, the IRS is asking a simple question:
Are these truly separate investments, or are they part of the same business operation?
If the same owners control both entities, the property exists to house the business, and the owner materially participates in running that combined operation, grouping is often allowed.
One thing that trips people up is that the activities may appear on different parts of the tax return — the operating business on a business return (or K-1) and the real estate on Schedule E. The grouping election doesn’t merge the entities themselves. It simply tells the IRS to treat those activities as one combined activity when applying the passive activity rules.
The election itself is not a checkbox. It’s typically made by attaching a disclosure statement to the tax return for the year the grouping begins.
The depreciation doesn’t disappear. It simply becomes passive and carries forward until it can be used.
Missing the grouping election in Year One is one of the most common reasons cost segregation doesn’t produce the expected tax result for business owners.
In some situations, the mistake can be corrected, but the process is not as simple as filing a Form 3115. A 3115 is used to correct depreciation methods, not passive activity elections.
Instead, the fix usually involves one of two paths:
- Amending the original return if the activities were already treated as grouped and the return is still within the amendment window, or
- Requesting late election relief from the IRS under Treasury Regulation §301.9100.
That relief process requires a formal request explaining why the election was missed and demonstrating that the activities were intended to operate as a single economic unit.
It can be done, but it is significantly more complex and expensive than making the election correctly in the first year.
The Self-Rental Trap: Why Increasing Rent to Your Business Creates a Bigger Problem
Once a business owner learns their depreciation is trapped as a passive loss, a logical-sounding workaround comes up.
The thinking goes like this: passive losses can only be absorbed by passive income. The real estate LLC currently shows very little income — rent comes in, expenses and depreciation go out, and the result is a net loss. So if passive income is what’s needed to unlock those losses, why not generate more of it? The operating company is already paying rent so why not raise it so that more money flows into the real estate LLC. Then, the LLC shows passive income, that income absorbs the passive losses, and the tax savings materialize.
It’s coherent logic. The problem is the tax code was written to block it.
The self-rental rule (Treasury Regulation 1.469-2(f)(6)) says that when you rent property to a business you actively run, any net rental income gets recharacterized as active income, not passive.
But the losses stay passive.
So if you raise rent enough that the real estate LLC shows $50,000 of net rental income, that $50,000 gets pulled out of the passive bucket and added to your taxable active income. The $250,000 of passive losses from depreciation stay exactly where they were, unable to offset any of it.
The result is more taxable income on the active side and passive losses still frozen so your tax bill has grown.
TLDR: Increasing rent to your own business doesn’t fix the passive loss problem. It adds to it.
The Tax Difference Between Having the Grouping Election and Not Having It
The same facts produce very different outcomes depending on whether the structure was set up correctly.
Without the grouping election:
- Business income: $400,000
- Cost seg depreciation from building: $300,000
- Depreciation is passive — cannot offset business income
- Taxable income: $400,000
- Current-year tax benefit from cost seg: $0
With the grouping election in place:
- Business income: $400,000
- Cost seg depreciation from building: $300,000
- Depreciation is non-passive — offsets business income directly
- Taxable income: approximately $100,000
- Tax savings at 37% bracket: roughly $111,000
What Happens If You Missed the Grouping Election
In some situations, a missed grouping election can be corrected.
If the election wasn’t formally made but the two activities were genuinely treated as one operation, there are IRS procedures that may allow a corrective amended return to establish the election retroactively. Whether that path is available depends on the specific facts and how the original returns were filed.
When a straightforward amended return isn’t an option, the next step involves formally requesting IRS permission to make a late regulatory election — a process that requires a detailed submission, can take several months, and involves professional fees along with IRS fees that can reach several thousand dollars.
There’s also a timing constraint: once three years have passed since a return was filed, amending that year becomes significantly harder. Each year of suspended losses that can’t be recovered adds to the cost of the original missed step.
These correction paths exist and work in the right circumstances. But the time and cost involved is significantly higher than making the election correctly in the first year.
What Needs to Be in Place Before the Tax Year Closes
Cost segregation accelerates deductions you were already entitled to take. But those deductions only produce current-year savings when the structure is in place to let them flow against income that’s being taxed right now.
For business owners buying the building their company operates in, these items need to be addressed in the same tax year as the acquisition:
Entity structure. The operating company and real estate holding entity should be properly separated — typically an S-corp or LLC for operations and a separate LLC for the property.
Grouping election. If the same person owns both entities, they operate at the same location, and the building exists for the business, the election should be drafted and attached to the Year One return.
Material participation. The owner needs to be actively involved in running the combined operation. For most owner-operators this is straightforward, but it should be documented — the IRS generally looks for 500 or more hours of participation in the activity during the year.
Cost segregation timing. The study should be completed in the same tax year as the acquisition so the depreciation and the elections align.
CPA coordination. All of this needs to be communicated before year-end, not at filing. The elections live on the return. If the preparer isn’t aware of the strategy in advance, the disclosures don’t get made.
The Bottom Line on Depreciation and Business Income
Depreciation is not the problem. Cost segregation works.
The issue is that most business owners treat the cost segregation study as the complete strategy. When it’s really just one piece of it.
The grouping election and entity structure are what allow the depreciation to actually reach the income that needs offsetting. Without them, the deductions are real but suspended…sitting in the passive bucket while active income gets taxed in full.
The study is worth doing. But the structure has to come first.
