Using Passive Loss Carry forward to offset "Boot" in a 1031 exchange

[jrfrerichs]

Why does boot from a 1031 exchange show up as a capital gain on my 1040 when I had a larger Passive Loss Cary forward on my 8582?

[Anonymous_ · Accepted solution]

I am not certain whether something untoward is happening in the software, but you might want to contact Support via the link below for a walk through on entering your exchange.

What is the TurboTax phone number? (intuit.com)

However, please take note that passive losses cannot be used to offset capital gains until those losses are released and such losses are not released until the property to which they are attached is disposed of to an unrelated third party in a fully taxable transaction.

[Critter-3]

I agree ... the passive loss you have on the old property transfers to the new property in a 1031 exchange ... it cannot cover the cap gain you may have in the exchange although boot is usually added to the cost basis of the new property.  Seek professional assistance on this return ... upgrade to the LIVE option if you are using the online program.  Best to pay a few $$ now to get this done correctly rather than pay much more later trying to correct an error. 

[jrfrerichs]

Thanks for your input. I have done some research on the issue and found the following:

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.

Given this guidance, I believe the program should have offset my capital gain (boot) with my Passive Loss Carry forward.

[jrfrerichs]

Thanks for the reply.  I did find the following guidance that indicated I should be able to offset the capital gain (boot) with my Passive Activity Loss carry forward. I just don't know how to effect that in Turbotax:

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.

[Critter-3]

If you did a 1031 exchange then you DID not sell the property ... you exchanged it.  Seek professional assistance to understand what you did and or how to do it in the TT program.  This is something that will not be straight forward in the program so seek help in some way.  

[Mike9241]

Yikes. you did a 1031 exchange without understanding its tax consequences. it's used to avoid getting taxed on the gain when real property is sold.  as such a 1031 exchange is NOT a fully taxable transaction.   wonder if you stepped through all the hoops of a 1031 transaction. miss just one and the 1031 fails and you are taxed on the entire gain.  see a PRO. 

[AmeliesUncle]

I haven't looked at the rules specifically for this situation, but I think the OP is correct.

Passive Losses offset Passive Income.   I would THINK the taxable "boot" from 1031 exchange of a PASSIVE property would be considered as Passive Income.  I don't see why it wouldn't be passive.  Assuming that is the case, the Passive Losses would offset that Passive Income.

As others noted, if the carryover losses exceed your Passive Income, that amount can not be used until you have Passive Income or the property is sold in a fully taxable transaction.

[Critter-3]

I am not sure what the OP actually did ...  who paid the boot ?   Did the OP receive the boot  or pay the boot ?   Makes a big difference.  OP needs professional assistance in this situation either way.  

[Anonymous_]

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@AmeliesUncle wrote:

I haven't looked at the rules specifically for this situation, but I think the OP is correct.

Passive Losses offset Passive Income.   I would THINK the taxable "boot" from 1031 exchange of a PASSIVE property would be considered as Passive Income.  I don't see why it wouldn't be passive.  Assuming that is the case, the Passive Losses would offset that Passive Income.

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Regardless, TurboTax will generally treat boot as being taxable as capital gain or ordinary income (recapture, per Sections 1245/1250, at rates no higher than the Section 1250 rate) in a transaction where any gain is fully deferred.

I am not certain how to indicate to the program that boot received should be offset to the extent of suspended passive losses. Typically, the program will release those passive losses upon a fully taxable transaction and they will wind up on Schedule E as a deduction. The program does a lousy job (or none whatsoever) of linking Schedule E, Form 8824, and, if applicable, Form 8582.

Again, the OP should contact Support for further assistance as there may be some methodology for input in this scenario (most likely involving Forms Mode).

As a final note, passive income is derived from passive activities and, as a result, such income is limited to income from rental activities and businesses in which the taxpayer does not materially participate. The sale of business or investment property does not generate passive income.