What is a 1031 Exchange?

If you own rental real estate, you are probably concerned about the tax hit you will take when you sell one property to invest in another property. If you talk to realtors or tax professionals about it, they would probably suggest that you consider a Section 1031 exchange.

So, what then is a 1031 exchange? It is a tax-deferred, like-kind exchange of one investment for another investment.

The Hasbro game Monopoly actually provides a great conceptual basis for how a 1031 exchange is intended to work.

Early in the game, you will use your cash to buy various properties. Eventually, one of the other players will acquire a property that you need and is not willing to sell it to you for cash (or you may not have enough cash on hand to buy it). Instead, the other player suggests trading his property for one of yours.

When this trade happens, you do not have to pay the bank for the difference in value between your property and the other player's property. It is simply a trade between the two players.

In the real world, you may acquire various investment properties throughout your life. At some point in your life, you may reach a point where you want to sell one of your investment properties and purchase another investment property. Without Section 1031, the owner of each property would have to pay income taxes on their individual gains from the sale of the properties. However, Section 1031 allows each landowner to simply trade their properties like they would in a game of Monopoly while deferring paying any taxes until the eventual sale (not 1031 exchange) of a property occurs.

Of course, few trades are this easy either in Monopoly or real life. In Monopoly, if the two properties do not have exactly the same value to both players, then the player with the more valuable property may demand money in addition to the property. While there are no consequences to that in the game, in real life the receipt of cash in a 1031 exchange is referred to as "boot" and is taxable. Even beyond the difference in values between the properties, few trades in the real world are as simple as they are in a game of Monopoly because many properties are burdened with mortgages which can have tax consequences. Furthermore, in the real world it can be difficult to find two landowners who are willing to trade properties, so to make a 1031 exchange work a qualified intermediary may have to be used to work around this problem.

Over the next few posts, we will discuss the formal requirements of a Section 1031 exchange, taxable transactions connected to a 1031 exchange, your basis in the new property, and transactions involving qualified intermediaries. In the meantime, if you would like to discuss 1031 exchanges or any other tax issue please send me an e-mail.

What Happens When You Sell a Passive Activity Business or Real Estate?

As you now know, if the passive activity rules apply to your business or real estate then you may not be able to deduct all your losses.  Passive activity losses can only be used to offset passive activity income (they cannot be used as a deduction against your ordinary income).  If you do not have any passive activity income, the loss is suspended and carries forward to the next year until you eventually have passive activity income.  But what happens if you dispose of the passive activity business or real estate before you are entitled to use all of the passive activity losses?

If that is the case, and it is the entire activity that is being disposed of, then special rules apply.  If the disposition is part of a fully taxable transaction (such as a sale), then the losses are recognized in the following order:

1) The current year passive activity losses are first used to offset all passive activity income from other activities for the year;

2) Then, the passive activity losses are deducted against ordinary income.

Lets look at an example to get a better understanding of what this means.

Joe is a limited partner in a small business, and owns one rental property.  Joe is not a real estate professional and does not actively participate in the management of his rental properties. In 2015, the small business will have income of $5,000.  The rental property has a loss of $3,000 prior to its sale during the year.  The property had a tax loss for a number of years prior, and had unused passive activities losses of $30,000.

Because the sale of the property is a taxable event and represents the complete disposition of his ownership interest in that property, Joe is allowed to recognize his prior unused passive activity losses.  First, though, he must offset the current year passive losses of $3,000 against the $5,000 of passive activity income from the small business.  After that, he is entitled to deduct the previously unused passive activity losses of $30,000.

However, the rules are different if the disposition of the business or real estate is instead the result of the owner's death.  In that case, the current year passive losses are still used to offset the current year passive activity income, but only to a certain extent.  They will only be allowed to be used to the extent that the losses exceed the "step-up" in basis that occurs when property is transferred through inheritance.  In other words, the losses are reduced by the amount of basis step-up.  Any unused passive activity losses then disappear- they cannot be used as a deduction against ordinary income.

If you have any questions, please send me an e-mail.

Are Real Estate Professional Affected by the Passive Loss Rules?

Over the past few blog posts we have been discussing what passive activities are, and how they can affect your taxes. Specifically, we discussed how all real estate investments are automatically considered to be passive activities, and that passive activity losses cannot be deducted against ordinary income. Instead, passive activity losses can only be used to offset passive activity income (which is taxed like ordinary income). We also discussed that certain investors who actively participate in the real estate activity are allowed to deduct up to $25,000 of losses as a special allowance, but that the special allowance begins to phase out if the investor has more than $100,000 of income from all sources. But what about real estate professionals? Real estate professionals are not simply investors who may own one or two rental properties, they spend most of their time involved in real estate and their income is typically very dependent on their real estate activities. Are real estate professionals limited to the same $25,000 special allowance that other real estate investors are limited to?

No, the Internal Revenue Code specifies that real estate professionals are exempt from the passive activity rules (for their real estate investments).

Who is a Real Estate Professional?

There are two requirements that must be met in order to qualify as a real estate professional for tax purposes:

1) More than one half (1/2) of the personal services you perform in all trades or businesses must be performed in real estate trades or businesses in which you materially participate (see the material participation rules here). The purpose of this rule is to ensure that only people who spend more time with real estate than other trades or businesses qualify.

2) You must perform more than 750 hours of services during the year in real estate trades or businesses in which you materially participate. This rule prevents casual investors who are not involved in other trades or businesses from claiming to be real estate professionals.

To be clear, there are a number of real estate activities that can qualify- it is not simply limited to rental activities. The Internal Revenue Code specifically lists the following activities that qualify as a real estate trade or business:

• Real property development;
• Redevelopment;
• Construction;
• Reconstruction;
• Acquisition;
• Conversion;
• Rental;
• Operation;
• Management;
• Leasing; and
• Brokerage.

Therefore, if you are a real estate professional, the passive activity rules do not apply to your real estate activities.  You are entitled to deduct those any losses from those activities against your ordinary income.

If you have questions about whether you qualify as a real estate professional, how the passive activity rules operate, or any other tax question please send me an e-mail.

Can Real Estate Investors Deduct Any Losses?

If you are a real estate investor or considering investing in real estate, you probably did not like the news that by default all real estate investments are considered to be passive activities.  As we previously discussed, you cannot deduct passive activity losses against "active" income, you can only use it to offset passive activity income if there is any.  However, there are exceptions to this general rule.  The first exception is for active participation in real estate investments.  If you qualify for this exception, you can deduct up to $25,000 of losses.

Only individuals, an individual's estate, or an individual's qualified revocable trust can actively participate in a rental activity.  You must also own at least 10% by value of all the interests in the activity throughout the year.

What does it mean to actively participate in the real estate activity?

Active participation is a fairly relaxed standard that can be met simply by making significant management decisions.  For example, this standard can be met by:

• Approving new tenants;
• Determining the rental terms; or
• Approving expenditures.

This is not an exhaustive list, so other similar decisions could be enough to qualify as active participation.

However, even if you actively participate in a real estate activity you may not be able to deduct the $25,000.  The $25,000 "special allowance" phases out based upon your income.  For every dollar of income you earn over $100,000 the special allowance decreases by $0.50 until it is completely phased out at $150,000 of income. 

If you would like to know more about the active participation exception to the passive activity rules, please feel free to send me an e-mail.

How Do I Know If My Business is a Passive Activity?

In the last post, I discussed the consequences of having your business be classified as a passive activity.  As I mentioned, any trade or business activity in which you do not materially participate is a passive activity to you.  But how do you know if you have materially participated?

Image borrowed from www.123rf.com

Luckily for you, there are 7 tests that answer this question, and you only need to "pass" one of them to avoid the "passive activity" treatment.

The material participation tests are:

1) You participated in the activity for more than 500 hours.  In general, any work you do for the business counts, unless it is the type of work not customarily done by the owner of that type of activity or your main reason for doing that work is simply to reach 500 hours.

2) Your participation was substantially all the participation in the activity of all individuals for the year, including participation of employees.  In other words, if you essentially run the business by yourself you do not have to worry about the number of hours you actually worked.

3) You participated in the activity for more than 100 hours during the year, and you participated at least as much as any other individual.

4) You participate in multiple trade or business activities, each for at least 100 hours, and combined they add up to more than 500 hours.  However, each activity in this grouping must be (if looked at individually) a passive activity.

5) You materially participated in the activity for at least 5 of the last 10 years.

6) You materially participated in a personal service activity for at least 3 years (regardless of how many years ago that was).  For these purposes, personal service activities include activities in the fields of health, law, accounting, or consulting, or any other activity for which your personal skills/services (not capital) is the primary income-producing factor.

7) An evaluation of the "facts and circumstances".  This is the least certain of all the material participation tests because you have to evaluate your situation and make a decision as to whether you materially participated, and hope that the IRS agrees.

If you satisfy any one of these tests, then you materially participated in your trade or business and are entitled to deduct the losses against your other income.

Please keep in mind that your real-estate related activities are considered to be passive activities regardless of whether your materially participated in them.  However, there are two exceptions that we will be discussing in the next blog posts.

If you have any questions about the passive activity rules and how they affect you, please send me an e-mail.

What Do You Mean My Investment is a Passive Activity?

Has anyone ever told you that your investment in a business or in real estate is a passive activity?  Do you know what that means?  Don't worry, most people don't.

Before 1986, investors would create tax shelters for themselves by putting their money into investments that would generate tax losses but no actual economic losses. For example, they may invest in a rental property and then would rent the property to a tenant for an amount equal to the monthly expenses. The investors would then have no net cash inflow or outflow, but would be able to depreciate the property and claim a tax loss.


Congress eventually caught on to the games that investors were playing with the Tax Code as it existed back then, and as a response invented the passive activity rules.

Under the passive activity rules, there are two types of passive activities.  The first type of passive activity are trade or business activities in which you do not materially participate.  In the next blog post we will discuss how this is determined.  The second type of passive activity are rental activities (although there are two exceptions that will be discussed in future blog posts).

The income and gains on passive activities will continue to be taxed just like any other ordinary income and gains. However, the losses on passive activities are not deductible but instead can only be used to offset passive activity income.  The passive activities losses are deferred until they can either offset passive activity income or the underlying investment is completely disposed of (e.g., sold).

In addition to not being able to deduct passive activity losses against your active income, the passive activity income is subject to the 3.8% Medicare Surtax.

Do you think you might have a "passive activity" investment?  If you would like to discuss whether it truly is a passive activity and how that affects your taxes, please send me an e-mail.

S-corp vs. LLC: Allocation of income and losses

As you have now discovered, there are a number of differences between S-corporations and LLCs. S-corporations have to follow the traditional corporate formalities, while the formalities that LLCs have to follow are far more relaxed.  There are also differences in the taxes and fees that they have to pay to California, and the types of compensation that the owners of each can take. The amount of flexibility you have in allocating income and losses between the owners is also a key difference.

The shareholders (owners) of an S-corporation must divide all income, gains, losses, and deductions in proportion to their ownership percentage.  Therefore, if you own 30% of an S-corporation then you will pick up 30% of the corporation's taxable net income on your tax return, and you are entitled to 30% of all the distributions made.

The members (owners) of an LLC, on the other hand, are allowed to have unequal allocation of income, gains, losses, and deductions as long as certain criteria are met. For example, you and your co-owner each own 50% of the LLC. You may have decided among yourselves that all of the depreciation deductions will be allocated to you, while all of the other items of income, gain, losses, and deductions will be split 50:50. You are allowed to do that as long as several requirements are met.  Those requirements are too complex to discuss in this blog, so I strongly recommend talking to a CPA if you are considering establishing an LLC whose operating agreement authorizes non-proportional allocation of income, gains, losses, and deductions.

If you have questions about the tax differences between S-corporations and LLCs, or if you would to talk about the requirements necessary in order to have non-proportional allocations in your LLC, please send me an e-mail.