What happens to Passive activity loss on 1031 exchange?

Question

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. ThanksSattir

Whitney Nash · Answer

@Sattir Bitti that is the way I understand it, yes, but again I would talk to your tax preparer to confirm that a 1031 is in your best interest. The deferral of depreciation recapture is also a good benefit of doing the 1031.To answer your other question, the replacement property needs to be of equal or greater value (less qualifying closing costs) than the value (sales price) of what you sold. FYI - You will also need to acquire equal or greater debt (loan or cash you contribute) on the replacement property than what you have on the relinquished property and use all of the remaining proceeds towards the purchase for full tax deferral.

Whitney Nash · Answer

Hello @Sattir BittiIf 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.

Carlos Ptriawan · Answer

on sale activity definitely YES as sale is "final disposition". I remember the exact rules number.But since 1031 is not an actual sale then we have to read the sample of this particular what-if tax exam situation. But in theory you should use the MACRS otherwise it doesn't make sense to carry forward the capital improvement to the next property.Yes understand the rules for this, is make or break decision for 1031.You ask so many good questions btw.....

Carlos Ptriawan · Answer

I've used aggregated PAL to reduce profit from flipping activity's capital gain.

Sattir Bitti · Answer

Thanks @Dave Foster, this seems exactly like what I need to do, sounds great when you can take a boot and push the depreciation recapture over to the new one!

Carlos Ptriawan · Answer

Also if you have $200K from your 1031 old property and you have 100k PAL from other property, you could , in all practical matter, "potentially" combine those to reduce for the next investment. So if your old property value is $1mil you could buy something for 700k. PAL is the most awesome thing in real estate. You don't really have to exchange 1 mil to another 1 mil. You could always downsize when you have PAL. Another way to reduce the tax obligation is to re-invest the debt portion into ZC coupon , it's almost like cutting tax portion by half LOL. Whoever invented this is genius :)

Carlos Ptriawan · Answer

take 200K cash from QI after the sale then , it is as simple as that

Carlos Ptriawan · Answer

You can offset PAL with the debt/equity portion. One of the best strategy !

Dave Foster · Answer

@Sattir Bitti and @Edward Stephens Depreciation recapture can impact you greatly. Which is one of the drivers for a 1031 exchange. However, it also may be possible for you to do what is called a "partial exchange" and still carry over the depreciation recapture and some of the profit in your 1031 exchange. You would do this by either purchasing less than your net sale. Or by taking cash "boot" which is treated as a taking of profit. Then when your accountant prepares your taxes they offset that gain with passive losses. With some coordination between you and your accountant, you should be able to get some tax-free cash from the sale and still complete a 1031 exchange to defer the rest of the tain and depreciation recapture.

Sattir Bitti · Answer

What happens to outstanding depreciation (MACRS) for roof or other capital improvements that's arent comoletely depreciated yet? Can the outstanding amount be added to the PAL on sale or 1031 exchange?