Super interesting tax quirk for those of you that invest in real estate

I had a call with someone yesterday that is underwater on a handful of properties acquired in 2022.

They aren’t a real estate professional and have a ton of suspended passive activity losses (PALs).

Here’s the quirk:

When you dispose of your entire interest in a passive activity in a fully taxable sale to an unrelated party, those suspended PALs are generally “released”.

First, they offset any gain recognized on the property being sold.

In this person's case (and for many investors who bought near the market peak) there isn't much gain to offset.

Any remaining suspended PALs generally become nonpassive losses under §469(g), meaning they can reduce other taxable income on the return.

Things like:

• W-2 income
• Business income
• Interest income
• Retirement distributions
• Capital gains

You don't generally get to "elect" what they offset. Since ordinary income is taxed at higher marginal rates than long-term capital gains, the practical effect is often that they reduce ordinary income first.

In this individual’s case, they have a concentrated stock position with a low basis that they want to get out of tax-efficiently.

Depending on their overall tax situation, selling some of the underperforming real estate could release suspended PALs that may reduce the overall tax burden.

Whether that’s:

• The concentrated stock
• Earned income
• Roth conversion
• RMD

The tax rules here are nuanced and highly fact-specific, but it's a fascinating example of why tax planning shouldn't happen one asset at a time.

Sometimes the best decision isn't about maximizing the return on a single investment, it's about optimizing the tax outcome of the entire balance sheet.

This post is for educational purposes only and isn't tax or legal advice. Work with your CPA and tax attorney before implementing any strategy.