Investors who want benefits like tax deferral and passive income find Delaware Statutory Trusts (DSTs) an appealing and suitable option. During your investment, however, you may encounter passive losses, particularly from the depreciation of the underlying DST properties. This accounting consideration raises a question: what happens to suspended losses after an exchange?
Below, Realized 1031 shares the answers to help you plan, especially if you want to reinvest into another DST after the holding period.
Based on the DST’s structure, and according to IRS rules, this investment is a passive activity. You’re not involved in the operational or business activities, in other words. As such, any income, losses, or deductions passed through to investors are considered passive. Passive losses are paper losses that arise from depreciation deductions that exceed the taxable income generated by the DST property. Passive losses can only offset passive income. Wages, dividends, or interest aren’t affected.
Passive losses become “suspended” losses because of the Passive Activity Loss (PAL) rules imposed by the IRS. If an investor doesn’t have enough passive income to use up the losses, the unused amount is carried forward indefinitely, or suspended, in other words.
A 1031 exchange allows you to defer capital gains taxes by exchanging two like-kind properties. DST interests qualify as like-kind properties thanks to Revenue Ruling 2004-86. After the holding period, you may plan to reinvest the proceeds in another DST, continuing the exchange cycle. In this case, how do suspended losses fit in this picture?
1031 exchanges “trap” suspended losses. What scenarios do they get freed or recognized for your own benefit?
Here are two common scenarios.
Suspended losses can be freed to offset net passive income in any future year. For example, if you have $5,000 in suspended losses for year 1, then you can use that to reduce taxable income in year 2. If your net passive income is $4,000 in year 2, then you can reduce it to $0, and the remaining $1,000 suspended losses carry over.
When you sell or dispose of your entire DST interests in a full taxable transaction, then the suspended losses can be used to lower DST gains, passive income from another source, and any other income.
Upon your passing, your DST interests gain a step-up in basis. While this process eliminates capital gains, it also eliminates your suspended losses. Your heirs cannot use them to offset gains in any way.
Passive losses, which become suspended losses when disallowed, are a powerful but misunderstood figure in DST investing. 1031 exchanges do not erase them, and when you do opt to finish exchanging, you can use the suspended losses to offset income and lower your tax liability. This strategic deferral means that while the losses may not be immediately usable, they are preserved as a valuable future tax shield.
Sources:
https://www.irs.gov/taxtopics/tc425
https://www.investopedia.com/terms/p/passive-activity-loss-rules.asp
https://calawyers.org/real-property-law/what-is-a-1031-exchange/