Owners of rental property who are not real estate professionals and whose income is more than $100,000 may have suspended passive activity losses. Those owners should be aware of the treatment of these suspended losses if they are contemplating a 1031 exchange.

Prior to 1986, a taxpayer could generally deduct losses in full from rental activities and trades or businesses regardless of participation. This gave rise to significant numbers of tax shelters that allowed taxpayers to deduct non-economic losses against wages and investment income. The Tax Reform Act of 1986 added IRC § 469, which limits the taxpayer’s ability to deduct losses from businesses and rental activities.

In general, losses generated by passive activities can only be used to offset income generated by passive activities. The renting of real estate is considered a passive activity. There are some exceptions to the general rule including the following:

• $25,000 Deduction: Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income is less than $100,000. To qualify for this offset, the taxpayer must actively participate (make management decisions), own at least 10 percent and not be a limited partner. The $25,000 exception is phased out at the rate of 50 cents for every dollar of MAGI over $100,000. Therefore, when MAGI exceeds $150,000, the $25,000 offset is not allowed.

• Real estate professionals: A real estate professional may be able to deduct all current rental real estate losses regardless of how high his MAGI might be. To deduct losses without limit, the taxpayer must spend more than half of his time in real property businesses and work more than 750 hours a year and materially participate (work on a regular, continuous and substantial basis in operations) in each separate rental real estate activity.

So what happens to the losses if the real estate owner is not a real estate professional and the $25,000 deduction is phased out? The real estate owner has suspended passive activity losses that can be carried forward indefinitely until there is passive income or an entire disposition in a fully taxable transaction.

Taxability of 1031s

Section 1031 provides an exception from the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of property. Under 1031(a), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held either for productive use in a trade or business or for investment. Section 1031 provides an exception only from current recognition of gain realized. The realized gain is deferred until the “exchange property” is disposed of in a subsequent taxable transaction. This deferred gain represents only a potential tax, which may be avoided altogether, for example, if the exchange property passes through an estate and its basis is stepped up to the date of death value.

If an exchange would be within the provisions of 1031(a) but for the fact that the property received consists of qualifying property and other property or money, the gain, if any, to the recipient is recognized to the extent of the sum of the money and the fair market value of the other property received. This “money or other property” is commonly called “boot” and includes liabilities assumed (or a transfer subject to a liability). “Other property” refers to property either specifically excluded (stock or trade, stock, etc.) or that which is not of like kind with property given in the exchange.

Passive Activity Losses

When a real estate owner disposes of his entire interest in a passive activity to an unrelated person in a fully taxable transaction, he may offset any gain with all passive activity losses allocable to the activity, not limited by the PAL rules. In a fully taxable disposition, all gain or loss is realized and recognized in the current year. An exchange of the taxpayer’s interest where all gain or loss is not recognized does not trigger suspended losses – such as transactions governed by IRC § 351, 721 or 1031. To the extent the taxpayer has recognized gain on the transaction, that income generally is passive and may be entered on Form 8582, triggering passive losses. 

An outright sale of the property, as opposed to a 1031 exchange, is generally advisable when the owner has substantial PALs that would offset the bulk of the realized gain. If the owner, however, has a substantial unrealized gain, his best option would be to do a 1031 exchange, using the PALs to offset boot recognized in the exchange. Alternatively, the owner could exchange the property to defer the gain and continue to carry forward the PALs until they can be used.

How or when is boot recognized in an exchange? The two most common examples are cash received at the closing of the property being sold or cash received at the end of the exchange because the real estate owner purchased a less expensive property. For example, if a real estate owner decides to sell his rental property for $500,000, he has a tax basis of $100,000 and $50,000 of suspended passive activity losses. If he simply sold the property outright, his $400,000 gain would be reduced by the $50,000 of PALs, leaving him with a $350,000 taxable gain. If he opted to do a 1031 exchange, he could arrange to receive $50,000 at the closing, exchange the rest and fully defer the gain. The $50,000 cash boot would be taxable but it would be reduced by the $50,000 in PALs, resulting in no gain being recognized.

Real estate owners with significant PALs should consult with their tax advisors before doing an exchange.