--- title: Does A 1031 Exchange Free Up Passive Losses? description: The only time it is possible for an investor to utilize their Passive Activity Losses (PALs) is during a 1031 exchange. image: https://www.realized1031.com/hubfs/two-buildings-sky-IS-1170143183.jpg --- [![Realized 1031 Exchange Marketplace](https://www.realized1031.com/hs-fs/hubfs/Images/Brand/Logo/Realized/Realized-Logo-Black.png?width=240&height=80&name=Realized-Logo-Black.png "Realized 1031 Logo") ](https://www.realized1031.com/) - [Wealth Management Gap](https://www.realized1031.com/the-wealth-management-gap) - [Our Process](https://www.realized1031.com/how-realized-works) - [Financial Advisors](https://www.realized1031.com/advisor) - [Resources](https://www.realized1031.com/resources) - [The Company](https://www.realized1031.com/about-us) - [Articles](https://www.realized1031.com/blog) [Register](https://www.realized1031.com/marketplace) [Log In](https://www.realized1031.com/login) - Better Business Bureau Rating: **A+** - [FINRA BrokerCheck](https://brokercheck.finra.org/firm/summary/22333) - [Call](tel:1-877-797-1031) **(877) 797-1031** # Does A 1031 Exchange Free Up Passive Losses? Posted Dec 8, 2020 ![two-buildings-sky-IS-1170143183](https://www.realized1031.com/hs-fs/hubfs/two-buildings-sky-IS-1170143183.jpg?width=750&height=392&name=two-buildings-sky-IS-1170143183.jpg) A passive loss occurs from a capital loss, or selling a property for less than you paid for it.  The only time it is possible for an investor to utilize their Passive Activity Losses (PALs) is during a 1031 exchange.            A PAL is one of two types of losses that can arise from owning investment property. The other type of loss is a Net Operating Loss (NOL). A NOL occurs when expenses of the operation of a property exceed the income.  ### What is Passive Activity Loss (PAL)? The IRS defines a passive activity in real estate investing as “any rental activity or any business in which the taxpayer does not materially participate.” In short, it means that any investment where the taxpayer is not heavily involved in the day-to-day activities of the business is considered passive. Income earned from passive activity is [passive income](https://www.realized1031.com/glossary/passive-income).  If the investor is involved in the operations and management of the business or property, the income earned is considered active income. For instance, if a taxpayer invests in a rental property and acts as the property manager, it would be an [active investment](https://www.realized1031.com/blog/active-vs-passive-investing-the-key-differences-to-know).  A PAL is a financial loss in an investment in which the taxpayer does not take part substantially. So, selling a passive investment for less than they paid for it.  In 1986, the IRS established guidelines to ensure investors do not use PALs to offset income from active investments. PALs can offset capital gains.  ### What Happens to PALs in a 1031 Exchange? If an investor has PAL on a passive investment, they can carry the loss over to future investments acquired through a 1031 exchange.   The PAL can continue to carry over and accrue until they dispose of the investment outside of a 1031 exchange. In a regular sale of the property, the loss is deductible. In an exchange, the loss is not deductible and is instead carried over.  The benefit of carrying over passive losses is the opportunity to make passive gains large enough to offset the loss. This is helpful with rental properties, which often show losses at some point.  Think of it this way, if you have underperforming property, you will have losses. The losses carry forward to a replacement property in an exchange. In this case, a 1031 exchange can get you out of a poorly performing asset into a new one. The loss goes with you from one investment property to the next until the property is sold outright.  There is a way to deduct the loss and also do a 1031 exchange by taking cash, or a [boot](https://www.realized1031.com/glossary/boot), out of the property before the sale instead of carrying it over. In this case, you can deduct the loss and get tax free cash. However, each property will have different circumstances, and the tax implications can vary. So, it is best to have each scenario evaluated by a tax professional to see if it is better to go with the boot or carryover the PAL.   This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. 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A NOL occurs when expenses of the operation of a property exceed the income. What is Passive Activity Loss (PAL)? The IRS defines a passive activity in real estate investing as “any rental activity or any business in which the taxpayer does not materially participate.” In short, it means that any investment where the taxpayer is not heavily involved in the day-to-day activities of the business is considered passive. Income earned from passive activity is passive income. If the investor is involved in the operations and management of the business or property, the income earned is considered active income. For instance, if a taxpayer invests in a rental property and acts as the property manager, it would be an active investment. A PAL is a financial loss in an investment in which the taxpayer does not take part substantially. So, selling a passive investment for less than they paid for it. In 1986, the IRS established guidelines to ensure investors do not use PALs to offset income from active investments. PALs can offset capital gains. What Happens to PALs in a 1031 Exchange? If an investor has PAL on a passive investment, they can carry the loss over to future investments acquired through a 1031 exchange. The PAL can continue to carry over and accrue until they dispose of the investment outside of a 1031 exchange. In a regular sale of the property, the loss is deductible. In an exchange, the loss is not deductible and is instead carried over. The benefit of carrying over passive losses is the opportunity to make passive gains large enough to offset the loss. This is helpful with rental properties, which often show losses at some point. Think of it this way, if you have underperforming property, you will have losses. The losses carry forward to a replacement property in an exchange. In this case, a 1031 exchange can get you out of a poorly performing asset into a new one. The loss goes with you from one investment property to the next until the property is sold outright. There is a way to deduct the loss and also do a 1031 exchange by taking cash, or a boot, out of the property before the sale instead of carrying it over. In this case, you can deduct the loss and get tax free cash. However, each property will have different circumstances, and the tax implications can vary. So, it is best to have each scenario evaluated by a tax professional to see if it is better to go with the boot or carryover the PAL. This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.", "articleSection" : [ "1031 Exchange" ], "author" : { "@type" : "Person", "email" : "marketing@realized1031.com", "image" : "", "name" : "The Realized Team", "url" : "https://www.realized1031.com/blog/author/the-realized-team" }, "dateModified" : "2020-12-08T19:12:11+0000", "datePublished" : "2020-12-08T19:12:11+0000", "description" : "The only time it is possible for an investor to utilize their Passive Activity Losses (PALs) is during a 1031 exchange. ", "headline" : "Does A 1031 Exchange Free Up Passive Losses?", "image" : { "@type" : "ImageObject", "height" : 468, "url" : "https://f.hubspotusercontent10.net/hubfs/733513/two-buildings-sky-IS-1170143183.jpg", "width" : 750 }, "mainEntityOfPage" : "https://www.realized1031.com/blog/does-a-1031-exchange-free-up-passive-losses", "name" : "Does A 1031 Exchange Free Up Passive Losses?", "publisher" : { "@type" : "Organization", "address" : { "@type" : "PostalAddress", "addressCountry" : "USA", "addressLocality" : "Austin", "addressRegion" : "TX", "postalCode" : "78701", "streetAddress" : "500 W 13th Street " }, "logo" : { "@type" : "ImageObject", "height" : 60, "url" : "http://www.realized1031.com/hubfs/Images/Brand/Logo/Realized/Realized-Logo-Black-No-Margin-296x60-AMP.png", "width" : 296 }, "name" : "Realized" }, "thumbnailUrl" : "https://f.hubspotusercontent10.net/hubfs/733513/two-buildings-sky-IS-1170143183.jpg" } ```