Residential real estate investors or investment property owners who are not classified as "real estate professionals" under the Federal income tax code and regulations may have suspended passive activity losses. These owners should be aware of the treatment of these suspended losses if they are contemplating a 1031 exchange.
Real estate investors or property owners could generally deduct all of their operating losses from rental or investment property activities regardless of the amount of time (participation) that he or she spent on the real estate activity prior to 1987. This resulted in a huge increase in the number of abusive income tax shelters that purportedly allowed investors to deduct losses against their taxable salaries and investment income.
The Tax Reform Act of 1986 put a stop to this. Investors are now limited to the total amount of losses from their investment real estate activities that they can deduct or offset against their taxable salaries and investment income, unless the investor materially participates in the rental or investment real estate activity.
The Treasury Regulations allow investors to deduct losses from their residential rental real estate activities if they materially participate in the investment real estate activity. Material participation is defined as actively managing, maintaining and repairing the rental or investment property, or actively overseeing the management of the rental or investment property. If a property management company is hired to manage the residential rental real estate, the investor must still participate in the management decisions such as approving tenants, approving the lease agreements and making decisions on maintenance and repairs in order to be classifed as materially involved.
If your gross before deducting any rental real estate losses is $150,000 or more, the losses are suspended, and you will not be able to deduct them against ordinary income in the year in which they occur. If your gross income before deducting the losses is $125,000 or less, you can deduct up to the full $25,000 limitation. Between $125,000 and $150,000, losses are reduced by one dollar for every two dollars of income above $125,000. For example, if your total income before the loss deduction is $137,500, you can deduct up to $12,500 of residential rental real estate losses.
If any part of your residential real estate rental losses are suspended, you don't lose them. They carry forward into future years and can be used when your gross income is less than the $150,000 limitation. The suspended losses can also be used to offset passive income in any year, including the year in which the losses occur.
In general, losses generated by passive activities can only be used to offset income generated by passive activities. The rental of real estate is considered a passive activity. There are some exceptions to the general rule including the following:
A. $25,000 Deduction: Rental real estate losses up to $25,000 may be deducted by an individual whose modified adjusted gross income (MAGI) 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.
B. 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 (works 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 (“PALs”) that can be carried forward indefinitely until there is passive income or an entire disposition in a fully taxable transaction.
If 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. A fully taxable transaction is one in which all realized gain is recognized.
If the owner has substantial PALs that would offset the bulk of his gain, then the owner would better off selling the property outright and not doing a 1031 exchange. 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 carryforward 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. An example illustrates how this would work. 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 income tax advisors before structuring a 1031 Tax Deferred Exchange transaction.