What Happens to Passive Losses in a 1031 Exchange?

What Happens to Passive Losses in a 1031 Exchange?
Written By
Carl E. Sera, CMT
Published On
March 17, 2023

Those who don’t classify as real estate professionals under the Federal income tax code and regulations should be aware of the treatment of passive losses. What happens to them in a 1031 exchange? Here’s what to know.

What Are Passive Activity and Passive Losses?

Passive activity occurs when a taxpayer does not materially participate during the tax year. The IRS defines two types: rental activities and business or trade activities to which taxpayers didn’t contribute and rental activities.

Passive loss is a financial loss within an investment in any trade or business enterprise where investors are not material participants. It can stem from investments in real estate properties, other activities where investors aren’t materially involved, and business partnerships.

Conditions for Passive Activity Losses

When a client becomes a passive investor in an investment property, their passive losses become deductible to an amount equal to their passive income. Current and suspended losses that become fully deductible only occur if there is a “qualifying disposition” on the property. There are three conditions for a qualifying disposition:

  • Disposition in a fully taxable event
  • Disposition of an entire interest in the activity
  • Disposition to unrelated parties

Treatment of Passive Losses in 1031 Exchanges

What are some exceptions to passive losses, and what happens to them in a 1031 exchange? Let’s find out.

Passive Activity Loss Exceptions

Losses generated by passive activities can only become active to offset income generated by passive activities. Real estate rental qualifies as a passive activity, but the rule has some exceptions. Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income remains less than $100,000.

The taxpayer must actively participate, not act as a limited partner, and own at least ten percent to qualify. The $25,000 exception gets phased out at 50 cents for every dollar of a MAGI over $100,000. Another exception is when a real estate professional can deduct all current rental real estate losses regardless of how high their MAGI resides. The taxpayer must spend more than half their life in real estate property businesses and work more than 750 hours a year by materially participating.

Treatment of Passive Activity Losses

Real estate owners can offset gain with all passive activity losses allocable to activity. They do this to dispose of their interest in a passive activity for an unrelated person in a fully taxable transaction not limited by the PAL rules. The treatment of passive losses in a 1031 exchange occurs if the owner of a substantial unrealized gain uses the PALs to offset the boot recognized in the exchange.

A few situations must occur to recognize a boot in an exchange. The first example is if cash is received at the end of the closing of the property being sold. Otherwise, the cash received at the end of the exchange results from real estate owners purchasing a less expensive property.

Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1-31 real estate into a securitized property while deferring taxes. Schedule a free 30-minute call today.

Carl E. Sera, CMT

Carl E. Sera, CMT

Managing Principal, Sera Capital
Carl Sera is a Chartered Market Technician and the Managing Principal at Sera Capital Management, LLC. He has over 16 years of experience in the financial services industry with a focus on investment management.

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