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My tax preparer says that I can do a 1031 exchange on a property which sells for $500k into a property selling for $550k and take cash out of escrow equal to the tax loss carry forward on the old property.

That sounds like boot to me.

To have a fully tax deferred exchange, you need to trade even or up in FMV of the properties, you need to trade even or up on the mortgage, and you can't get any cash out of the exchange.

Also, don't just look at the cash - payment of operating expenses in escrow is also receipt of boot. So things like interest on the mortgage, property tax prorations, insurance, and paying the new owner prorated rents on the old building through escrow can give rise to boot. Many people get caught in that trap. It's not really a disaster, but it does make a (sometimes small) part of the transaction taxable.

With that out of the way, perhaps your tax preparer is suggesting to deliberately recognize some gain on the exchange to offset your passive loss carryforwards. Since an exchange is not a fully taxable transaction, any passive losses you have on the old property are not automatically released. They would continue to be recognized as allowable with the new property.

Personally, I don't see much benefit. The recognized gain will basically increase your basis in the new property and give you bigger depreciation deductions on it in the future. And if you have a passive loss problem, that will make your future passive losses bigger. So over the course of several years, it won't make much difference.

However, there might be a small current benefit. The passive losses will be recognized at your marginal rates, but the gain will be taxed at lower rates. It's not going to be a huge difference.

Depending on how big your total potential gain is on the old property and how much in passive loss carryforward you actually have, you may want to consider just scrapping the 1031 exchange, recognize the gain, and take advantage of your passive loss carryforwards. This probably makes sense only if the loss are roughly equal to your total potential gain. If the gain is very large in comparison to the losses, then the exchange could easily be worth the effort (and cost).

--Peter
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