Many times, in the context of a client selling property and exchanging into another property, the client may assume that he or she can net their prior passive activity losses against their gain on the sale of their asset and exchange the balance into another property.

Where a client is considered to be a passive investor in an investment property, their passive losses are deductible to an amount equal to their passive income. Furthermore, current and suspended losses are fully deductible if there is a “qualifying disposition” of property. A “qualifying disposition” requires three conditions:

1. Disposition of an entire interest in the activity (or substantially all). This may be influenced by prior tax grouping elections as to whether one or more properties are grouped as one activity and whether the taxpayer can segregate his or her books and records on a property by property basis.
2. Disposition in a fully taxable event (where all gain/loss is realized and recognized).
3. Disposition to an unrelated party. Related parties are defined under both Section 1031 and passive activity loss rules.

If these three tests are met, losses are fully deductible against non-passive income (unless the taxpayer has basis limitations). Thus, in the year of disposition, losses allocable to the passive activity may offset portfolio and other investment income or may become part of a net operating loss.

If the taxpayer made an election to group his rentals as a single activity under Reg. §1.469-9(g), the sale of one property would not constitute an entire disposition.

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, IRC §721 or Section 1031.

When debts are discharged in bankruptcy, to the extent cancelled debt is not taxed,  the amount of the debt forgiven absorbs certain tax attributes including passive losses. Passive losses which have been absorbed by cancelled debt are not deductible. For individuals who file for bankruptcy under Chapter 7, the unused passive activity losses and credits are transferred to the bankruptcy estate.

If the taxpayer sells a passive activity on an installment basis, current and suspended losses may only be deducted in the same ratio as the gain reported. If there is excess gain, that gain is passive income under Reg. §1.469-2T(c)(2)and will permit deductibility of additional losses to the extent of the gain.

The sale of land (whether leased or held for investment, self-rented property, a building not used in a passive activity in the year of sale) and the sale of a rental where the taxpayer is a real estate professional are not subject to the passive activity loss rules..

If the taxpayer is in bankruptcy, a transfer of a passive activity to a bankruptcy estate does not constitute an entire disposition in a fully taxable transaction (in other words, gain or loss has not been recognized). If bankruptcy is complete, current and suspended losses are applied against any mortgage or other debt forgiven.

For more information on 1031 exchanges, contact the tax attorneys at All States 1031 Exchange Facilitator at 877-395-1031.