On your blog dated 9/27/2022 titiled Disadvantages with REPS, you have mentioned that one will not be allowed to do 1031 if all properties are grouped together as one would need to exchange the entire group. Can you pelase provde more details as I thought as long as the rental real estate is excahnged for another rental real estate, it should be ok. Really like your articles.
Thank you,
Sumeet, WA
Hello Sumeet,
Thank you for your question regarding my earlier blog about the disadvantages of the Real Estate Professional status, specifically with regards to the grouping of activities in order to more easily satisfy the material participation requirements for the RE Pro status.
You asked if we could provide more details regarding the disposition of a grouped activity, as you believed that as long as you exchange one rental real estate property for another, it was okay. And technically speaking, you are correct that you can do a tax-free exchange of one rental real estate property for another. This is usually called a “like-kind” exchange.
In my previous blog, I said that you could not claim your suspended passive losses in a grouped activity until the entire activity was disposed of. I later stated that “Another disadvantage would be if you want to perform a like-kind exchange on the property in the group; in that case, you may need to exchange the entire group, rather than just a portion of it.”
But what if you want to exchange or sell just one of the properties in a group/activity? In that case, Section 469(g) of the Internal Revenue Code requires the entire group/activity must be disposed of in a “fully taxable transaction.” In fact, this section of the IRC is titled, “Dispositions of Entire Interest in Passive Activity” [emphasis added]. And when the Code says “entire,” it means the whole thing. Only then do you get to treat any excess loss as a deductible loss, and only if you are not doing a like-kind exchange. Even if you exchange the entire grouped activity, if you do so in a tax-free like-kind exchange, it is not the required “fully taxable transaction” required by Section 469(g) – it’s tax free, not taxable. So those suspended losses you’ve had on that group can only be recognized when you later dispose of your entire interest in the property that you received in the tax-free exchange in a taxable transaction.
For example, let’s say you have two residential real estate properties that are grouped together as one activity and, combined, they have suspended passive losses of $100,000 and are worth $300,000 each, or $600,000 total, but your basis in them is $200,000 total for the properties. You are tired of the hassle of being a landlord and decide to do a tax-free exchange of the two homes into a single commercial property (this would be considered like-kind even though you are trading noncommercial rentals into a commercial rental). To execute the exchange, you engage a qualified intermediary and sell the two homes for $300,000 each, with the intermediary handling the cash for you. Then, in the prescribed time, you purchase a commercial real estate property for $1.2 million, paying $600,000 in cash and financing the other $600,000 with a mortgage. Therefore, you have no gain recognized from the exchange (even though you have an unrecognized gain of $400,000, the difference between your basis and the FMV of the properties).
Because you had no “fully taxable transaction” in this exchange, the $100,000 of suspended passive losses is now attached to your commercial property. You do not get to claim it in the year you execute the exchange. If you later sell the commercial property, rather than trading it for another property, you can then claim the $100,000 of suspended losses to reduce any gain from that sale or increase your loss.
However, the IRS does permit you to dispose of a “substantial part” of an activity and recognize the suspended passive losses. To do this, you must be able to establish with reasonable certainty the amount of disallowed deductions and credits allocable to that part of the activity for the tax year, and also the amount of gross income and any other deductions or credits allocable to that part of the activity for the tax year. While “substantial part” isn’t clearly defined, we can probably assume it means more than 50% of the activity, but remember, the IRS can always challenge a determination. What you may consider to be substantial, they may not agree is substantial. And also, it is not clear what is meant by “part” – do they mean that property’s share of the suspended losses? The fair market values? The basis? It’s not really defined by the IRS what they mean by “part.” And again, in order to claim the suspended losses, the disposition of the “substantial part” would need to be a fully taxable transaction, not a like-kind exchange.
Tax-free like-kind exchanges have many requirements in order to make them tax free, and they are not something a taxpayer should contemplate doing without professional advice. Another thing that might come up in trying to perform a like-kind exchange of grouped activities is if the group is treated as one property for purposes of the exchange or is treated as multiple properties (within the group). There are limits on how many properties can be exchanged in a tax-free exchange, so this is an important consideration. But that’s a topic for another blog.
We hope this helps answer your question.
Sincerely,
Carolyn Richardson, EA, MBA