1031 Exchange and Passive Activity Losses

What Are Passive Activity Losses?

The Tax Reform Act of 1986 established IRC § 469 to prevent high-income taxpayers from using rental losses to shelter unrelated earned income. Under the passive activity rules, losses from rental real estate (and other passive activities) can only offset passive income — they cannot offset wages, business income, or portfolio income such as dividends and interest.

There are two narrow exceptions that allow rental losses to offset ordinary income:

• The $25,000 allowance (IRC § 469(i)): Taxpayers who actively participate in rental activities and whose adjusted gross income is below $100,000 may deduct up to $25,000 of rental losses against non-passive income. This allowance phases out completely at $150,000 AGI.
• Real estate professional status (IRC § 469(c)(7)): Taxpayers who spend more than 750 hours per year in real property trades or businesses, and for whom that time represents more than half their total working time, can treat rental activities as non-passive — effectively unlocking all rental losses against any income. More on this below.

When neither exception applies, losses in excess of passive income in a given year are suspended: they carry forward indefinitely until the taxpayer has passive income to absorb them or disposes of the activity in a fully taxable transaction.

How Suspended PALs Accumulate

A rental property investor with $350,000 in wages and $400,000 in other income is well above both the $150,000 AGI phase-out and the practical reach of the $25,000 allowance. Each year, if the rental property generates a tax loss — through depreciation, interest expense, operating costs — that loss is suspended and added to the carryforward balance.

It is common for a landlord who has held a property for 10–15 years to have accumulated $80,000–$150,000 or more in suspended PALs. Depreciation on a $1M residential rental at the 27.5-year straight-line rate is approximately $36,000 per year before any operating costs — in a year with no operating loss and full occupancy, the depreciation alone can generate a sizable tax loss that is entirely suspended at high income levels.

What a 1031 Exchange Does (and Doesn't Do) to Suspended PALs

The straightforward answer: a fully tax-deferred 1031 exchange does not release suspended passive activity losses. They do not flow through to your tax return in the year of the exchange. They carry over, attached to the replacement property's activity, and remain suspended until a qualifying event occurs.

The reason is that IRC § 469(g)(1) provides for the release of PALs only on a "fully taxable" disposition of the passive activity — meaning the gain must be recognized in full, with no nonrecognition provision applying. A 1031 like-kind exchange is specifically a nonrecognition transaction under IRC § 1031. The exchange does not produce a recognized gain, so the disposition is not "fully taxable," and § 469(g) does not trigger the PAL release.¹

The Boot Exception: Partial Release on Recognized Gain

There is one partial exception that matters in practice. When a 1031 exchange includes boot — cash received or a net reduction in debt — gain is recognized up to the boot amount. That recognized gain is characterized as passive income from the relinquished activity in the year of exchange. Under § 469, passive income from an activity can absorb suspended losses from that same activity in the current year.²

In other words: if the exchange produces $30,000 of recognized gain from boot, and the investor has $95,000 in suspended PALs, the $30,000 recognized gain is offset by $30,000 of the suspended PALs — leaving $65,000 still suspended and carrying over to the replacement property. The exchange does not release losses beyond what the recognized boot income can absorb.

When Do Suspended PALs Finally Release?

Suspended PALs from a rental property (including any PALs that carried over through one or more 1031 exchanges) are released in full when the investor makes a fully taxable disposition of the activity — that is, when the replacement property is ultimately sold in a taxable transaction where all gain is recognized.¹

At that point, the full amount of suspended PALs from the entire history of the activity (including carryovers from prior exchanges) becomes deductible against income in the year of sale. They offset the recognized gain first, then any remaining amount can offset non-passive income — wages, interest, dividends, business income — without limitation.

Other events that release PALs:

• Installment sale (if all remaining payments are treated as received in the year of sale) — see the installment sale rules for nuances on installment reporting
• Casualty or involuntary conversion — depends on whether the proceeds are reinvested in qualifying replacement property
• Death of the taxpayer — suspended PALs are generally lost at death (the stepped-up basis at IRC § 1014 eliminates the gain that would have released them, but the PALs themselves do not transfer to heirs and expire unused)³

Strategies to Accelerate or Plan Around Suspended PALs

Strategy 1: Real Estate Professional Status (REPS)

The most powerful tool for unlocking rental losses is qualifying as a real estate professional under IRC § 469(c)(7). The requirements are strict:⁴

• More than 50% of the taxpayer's total personal service hours during the year must be in real property trades or businesses in which the taxpayer materially participates
• The taxpayer must spend more than 750 hours per year in those real property activities

If REPS is met and the taxpayer also materially participates in the specific rental activity, the rental losses are reclassified as non-passive for that year. This means current-year rental losses — from depreciation, interest, operating expenses — become deductible against wages and other ordinary income. It does not automatically unlock prior suspended losses, but once REPS is established, the investor can also make an election to aggregate all rental activities into one activity (Treas. Reg. § 1.469-9(g)), which makes material participation easier to satisfy across a portfolio.

Practically: a spouse who manages the properties full-time, or an investor who has shifted out of a W-2 career and now devotes the majority of working hours to real estate, may be close to the REPS threshold. Crossing it changes the math on the entire rental portfolio, including suspended loss carryovers that arose before REPS was established (those prior PALs remain suspended until a taxable disposition — REPS does not retroactively release them, but it prevents future losses from being suspended).

Strategy 2: Accept Strategic Boot to Offset PALs

For an investor who has both a large suspended PAL carryforward and some flexibility in how tightly they reinvest, accepting a measured amount of boot creates passive income in the year of exchange — income that is directly absorbed by the suspended PALs before any regular tax applies. The net result: the boot is taxed at zero or reduced cost, because the PALs offset the recognized gain.

The tradeoff is that boot reduces the equity deployed into the replacement property, which may mean a smaller property, more mortgage debt, or lower future income. The decision to accept boot strategically requires comparing the tax value of the PAL absorption against the long-term opportunity cost of a smaller replacement investment. A financial advisor can model this comparison precisely before the exchange closes.

Strategy 3: Cost Segregation on the Replacement Property

A 1031 exchange carries over the relinquished property's carryover basis to the replacement property. The replacement property's depreciable life schedule resets based on its new depreciable components — but the carryover basis means the starting depreciation base is lower than the full purchase price. Cost segregation — reclassifying components of the replacement property into 5-year, 7-year, or 15-year property to accelerate depreciation — can generate large first-year deductions on the replacement property's incremental value above the carryover basis.

Under OBBBA (July 2025), 100% bonus depreciation was permanently restored for property placed in service after January 19, 2025.⁵ This means cost-segregated components on the replacement property can potentially generate substantial first-year losses — which are passive losses. They do not absorb the prior PAL carryforward (passive losses do not offset passive losses), but they do reduce current-year passive income. For investors who also have passive income from other sources (limited partnerships, other rentals, publicly traded partnerships), cost segregation can optimize the overall passive income/loss position across the portfolio.

Strategy 4: Portfolio Passive Income

Suspended PALs can be used against passive income from any source — not just the relinquished property's activity. If the investor has other passive activities (real estate limited partnerships, publicly traded partnerships that generate passive income, other rental properties with positive taxable income), that passive income absorbs the suspended PALs in the current year. The replacement property itself may generate passive income after the exchange, which slowly draws down the PAL carryforward year over year without requiring a taxable sale.

Worked Example: $700K Fourplex with $92,000 in Suspended PALs

Patricia bought a Los Angeles fourplex in 2010 for $500,000. She has never qualified for REPS and her AGI has exceeded $150,000 throughout the hold period. Over 15 years, accumulated depreciation (straight-line, 27.5-year) and operating losses have generated $92,000 in suspended passive losses.

Scenario A: Full 1031 Exchange (No Boot)

Patricia completes a fully deferred exchange into a San Diego apartment building at $1,800,000. Federal tax deferred: approximately $332,000 (§1250 at 25% + LTCG at 20% + 3.8% NIIT on gain above thresholds). Suspended PALs: $92,000 carries over to the San Diego property, still suspended, still unavailable to offset wages. The exchange defers the tax but does nothing for the PAL problem.

Scenario B: Exchange with $60,000 Boot

Patricia takes $60,000 in cash at close (reducing her reinvested equity). That $60,000 boot is recognized gain — all of it is characterized as passive income from the fourplex activity. The $60,000 recognized gain absorbs $60,000 of the $92,000 suspended PALs in the year of exchange. Net tax on the $60,000 boot: zero (fully offset by PALs). Remaining suspended PALs: $32,000, which carry over to the replacement property.

Patricia nets $60,000 in tax-free cash and clears most of her PAL backlog. The tradeoff: $60,000 less equity goes into the replacement property, potentially requiring more mortgage debt to hit full deferral on the remaining gain. Whether this is worth it depends on the replacement property's return on that incremental equity versus the value of unlocking $60,000 in PALs she might have carried for another decade.

Scenario C: Taxable Sale (No Exchange)

Patricia sells without exchanging. Total federal tax: §1250 recapture $272K × 25% = $68,000 + LTCG $1,250K × 20% = $250,000 + 3.8% NIIT on gain above $250K threshold ≈ $48,660 = approximately $366,660 total federal tax. Against this, the $92,000 in suspended PALs are fully released in the year of sale — they offset passive income first (the recognized gain is passive income from the disposed activity), reducing the effective tax by approximately $92,000 × combined rate ≈ $33K–$37K. Taxable sale clears the PAL backlog but at the cost of $366K+ in immediate federal tax.

How a Fee-Only Advisor Handles the PAL Decision

The interaction between suspended PALs and a 1031 exchange is one of the more nuanced parts of the exchange decision — and one that is frequently undermodeled. Your qualified intermediary does not analyze PALs (that is your CPA's domain). Your CPA can confirm the carryforward balance but may not specialize in 1031 exchange strategy. A fee-only financial advisor who works with real estate liquidity events can:

• Quantify the full PAL balance and translate it into a dollar value at your effective marginal rate, so the "PAL opportunity cost" is visible in the exchange decision
• Model the strategic boot scenario — how much boot maximizes PAL absorption without creating cash boot that triggers recapture before LTCG thresholds are crossed
• Evaluate REPS eligibility — particularly for investors who are approaching retirement or whose spouse's time allocation has shifted, REPS may be closer than it appears
• Project PAL absorption on the replacement property — if the replacement property generates taxable passive income each year, the carryforward draws down over time; the advisor can show how many years it takes to fully absorb the backlog at projected income levels
• Integrate the PAL analysis into the full exchange-vs-taxable-sale model — including depreciation recapture, NIIT, state taxes, and the long-term value of the deferred gain compounding in the replacement property

See the financial advisor for 1031 exchange guide for what the full advisory team looks like and where the financial advisor fits alongside the CPA, QI, and attorney.

For a broader look at how depreciation from a prior property carries through an exchange, see the depreciation recapture and carryover basis guide.

Sources

1. IRC § 469(g) — Treatment of passive activity losses and credits upon disposition of interest in activity. Release of suspended losses requires a fully taxable disposition; nonrecognition transactions (including § 1031 exchanges) do not qualify. law.cornell.edu/uscode/text/26/469
2. IRC § 469(g)(1)(A) — Suspended losses allowed in the year of disposition; recognized gain in a partially taxable exchange (boot) is characterized as passive income from the disposed activity, absorbing suspended PALs up to the recognized amount. See also The Tax Adviser, "Disposing of Passive Activities" (AICPA, April 2017).
3. IRC § 469(g)(2) — Suspended losses in excess of the gain recognized at disposition are allowed in the year of disposition against all income. However, at death, the stepped-up basis under IRC § 1014 eliminates the underlying gain, and suspended PALs that arose from the activity expire unused — they are not transferred to or usable by the estate or heirs. See Realized 1031, "Does A 1031 Exchange Free Up Passive Losses?"
4. IRC § 469(c)(7) — Real estate professional status: taxpayer must perform more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates, and such services must constitute more than half of the personal services performed by the taxpayer. law.cornell.edu/uscode/text/26/469
5. One Big Beautiful Bill Act (OBBBA), signed July 2025 — permanently restored 100% bonus depreciation for qualified property placed in service after January 19, 2025, reversing the phase-down schedule under TCJA. Applies to cost-segregated components on replacement property acquired in a 1031 exchange. IRS.gov

PAL rules reflect IRC § 469 as in effect for tax year 2026. REPS threshold (750 hours, majority-of-services test) has not changed under OBBBA or recent legislation. The $25,000 rental allowance phaseout range ($100,000–$150,000 AGI) is not inflation-adjusted and has not changed. Suspended PAL balances and carryforward calculations depend on each taxpayer's specific activity history — consult a CPA or tax attorney for analysis of your carryforward balance before making exchange or sale decisions. Values and scenarios verified against 2026 tax rules as of June 2026.

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