Understanding Passive Activity Losses in the Context of a 1031 Exchange

What Investors Should Know About Loss Treatment, Participation Rules, and Tax Timing

For real estate investors considering a 1031 Exchange, it’s important to look beyond capital gains deferral. One often-overlooked element is the treatment of passive activity losses (PALs). These losses—typically generated from rental real estate—can play a significant role in an investor’s overall tax strategy, especially when selling a property involved in a 1031 Exchange.

This article breaks down how passive activity losses are treated during a like-kind exchange, and what factors—like participation status and income thresholds—may affect the timing and use of these losses.

How Passive Activity Losses Are Treated in a 1031 Exchange

Under the tax code, losses from passive activities, such as rental real estate, are generally suspended unless the investor has other passive income to offset them. These suspended losses usually remain on the books until the investor completely disposes of the passive activity in a fully taxable transaction.

In a 1031 Exchange, however, the property isn’t sold in a taxable event—it’s replaced with like-kind property. As a result, the exchange does not trigger the release of those suspended passive losses. Instead, the losses carry forward and remain tied to the replacement property.

Operating Losses from Investment Property

Investors with negative cash flow may accumulate significant operating losses over time. These losses—caused by depreciation, repairs, or vacancies—can become passive activity losses unless the investor qualifies as a real estate professional or materially participates in the activity.

In a traditional sale, these operating losses could be released and used to offset gains. But in a 1031 Exchange, since the sale isn’t fully taxable, those losses are not realized or deductible in the current year.

Passive vs. Material Participation

Whether an activity is considered passive or active depends on the investor's level of participation in the operation of the property. According to IRS rules:

• If the investor is materially involved in the day-to-day management, the losses may be considered active and can offset other types of income.

• If the investor’s involvement is limited, the activity is passive, and any losses are generally suspended unless offset by passive income.

This distinction is crucial for determining how losses are handled in both 1031 Exchanges and general tax planning. Material participation can unlock the current-year use of losses, while passive participation may result in deferral.

Adjusted Gross Income and Loss Limitations

The IRS limits the amount of passive losses that can be used based on the investor’s adjusted gross income (AGI). Specifically:

• Investors with an AGI of $100,000 or less can deduct up to $25,000 in passive losses annually.

• This deduction phases out completely once AGI exceeds $150,000.

However, these thresholds only apply to active participants in rental real estate. Investors who don’t qualify under this rule will have their losses suspended—again, with no release upon exchanging property under Section 1031.

Suspended Losses and the 1031 Exchange Continuum

Suspended passive losses effectively “travel” with the relinquished property. When the investor performs a 1031 Exchange, those suspended losses do not disappear—they remain in place and attach to the replacement property.

This continuity allows for future tax planning. If the investor eventually sells the replacement property in a fully taxable transaction, the suspended losses associated with the original property can then be released and deducted.

Summary: Can Passive Losses Be Used in a 1031 Exchange?

In short, no—not immediately. Passive activity losses cannot be claimed at the time of a like-kind exchange because the IRS does not consider it a taxable disposition. However, the good news is that those losses are not lost; they’re merely deferred, just like the capital gains.

To optimize outcomes:

• Track suspended losses diligently, especially across multiple exchanges.

• Consult a tax advisor to determine whether your participation status could allow current use of losses.

• Strategically time a taxable disposition if you're looking to unlock and deduct suspended PALs.

Real estate investors aiming to build long-term wealth through 1031 Exchanges should be aware that passive losses are an important—but often misunderstood—piece of the tax puzzle. By understanding how these losses are treated and how to plan for their eventual use, investors can better manage their tax exposure across multiple transactions.