1031 Exchanges on Property with Passive Activity Losses

Prior to 1986, taxpayers bought real estate for their tax losses as much as for their investment potential. I remember those days and it seemed that in many cases the investor was only interested in the amount of loss that a property could throw off. High-income individuals used these losses to reduce the tax on their high personal income.

Not surprisingly then, in 1986 Congress enacted what we now call the passive activity loss rules to limit a taxpayers ability to use losses from rental property to shelter their other income. In simple terms, the passive activity rules now provide that you can’t, subject to certain limitations, use the losses from a passive activity to shelter other taxable income. Real estate is a classic example of a passive activity. If you’re subject to the passive activity loss rules, you very much know it. The subject of this article is what do you do with your carryover losses when you sell real estate and roll over the gain with a 1031 exchange.

. . . Section 1031 allows the deduction of the loss under the passive activity loss rules. In other words, you get tax-free cash. . . 

If you’re subject to the passive activity rules, and your purple duplex rental property generates a loss in year one, that loss is not deductible – it carries over to year two and you offset it against the year two income from the purple duplex. If you don’t have enough income in year two to offset the loss, the difference carries over to year three. If you have a loss in year two, the loss is added to the loss from year one and the combined loss is carried over to year three.

Let’s take an example: in year one the duplex has rental income of $25,000, but deductions and depreciation of $35,000. Because you’re subject to the passive loss rules you are unable to deduct anything and you carry over the undeducted passive loss of $10,000 to year two. In year two you have net rental income of $2,000. You would offset the $10,000 carryover against this, resulting in $0 rental income in year two, and you’d carryover the difference of $8,000 to year three. In year three you have a loss of $5,000, so your passive loss carryover to year four is $13,000.

So what happens if you sell the duplex at the end of year three? Your accumulated loss of $13,000 is deductible from the gain or loss from the reported sale. If your gain on the duplex was $50,000, you’d only pay tax on $37,000. In other words, your passive loss carryover doesn’t disappear, it was simply held in suspense until you dispose of the property.

So what happens if you do a 1031 exchange when you sell your duplex? When you do a 1031 exchange the way the IRS views the transaction is that you haven’t sold the property, you’ve merely changed the legal description from that of the old property to that of the new property which is why the sale is not taxable. Therefore, if you do a 1031 exchange on the duplex, you’ve not sold the property, and therefore the passive loss carryover of $13,000 is not deductible. So what happens to it? It transfers to the new property that you bought in your exchange and will continue to accumulate with losses from the new property until you sell the new property and don’t do an exchange.

So is there a way for you to deduct the loss and yet still do a 1031 exchange? Yes: the way to do this is to take cash (what the IRS calls boot) from the sale of the property. In my example, you would take $13,000 cash at the time of the sale. The $13,000 is taxable under the rules of Section 1031, but allows the deduction of the loss under the passive activity loss rules. In other words, you get tax-free cash.

There are a couple of things you need to be aware of: first, the $13,000 of boot and the $13,000 passive loss are subject to different tax rates. Most people will get a larger tax benefit from the loss than the rate of tax that they will pay on the boot, but it could affect you differently. Second, you need to know the amount of your passive loss carryover and communicate this to your 1031 intermediary before the closing so that you can take that amount of cash from the sale. If you don’t, and the money goes to your qualified intermediary, it will be tied up until the end of your exchange.