What happens to Passive activity loss on 1031 exchange?

[Sattir Bitti]

Hi,

When 1031 exchange is performed, what happens to the Passive Activity loss on original property? We have considerable PAL and good equity on the original property, wondering what happens to this loss after the exchange. 

Thanks

Sattir

[Whitney Nash]

Hello @Sattir Bitti

If you have some PALs on a passive investment and significant gain, you can carry the loss over to future investments acquired through a 1031 exchange. (In a regular sale of the property, the loss is deductible.) It can continue to be be carried over by doing multiple exchanges over time until a property is sold outside of an exchange. There is a way to deduct the loss and also do a 1031 exchange by taking cash, or boot, out of the property at the time of the sale instead of carrying it over. In this case, you can deduct the loss and get tax free cash. 

Here's an example to illustrate how this could work. Sell a rental property for $500,000 with a tax basis of $100,000 and $50,000 of suspended PALs. If you sold the property outright, your $400,000 gain would be reduced by the $50,000 of PALs, leaving you with a taxable gain of $350,000. If you did a 1031 exchange instead, you could 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 which would result in no gain being recognized.

If you have substantial PALs that would offset the bulk of your gain, then you might be better off selling the property outright and not doing a 1031 exchange. Each situation will have different circumstances, and your tax implications can vary. I highly recommend having your scenario evaluated by a tax professional to see which direction might be best for you.