Using Carry Forwards

[Deleted]

As follow up to my prior thread (Forgot to Depreciate...) we discussed using our accumulated operating "carry forwards". Must one dispose of a property in order to free up and use the carry forwards and must they only be used to offset income?

Here's what I'm thinking about. In my prior example, I stated that one option was not to sell but to move back into the house. If we choose that option, one of our other options to free up some cash would be to sell another house that we own. We acquired it via a 1031 exchange the beginning of 2005. Although the house is worth less than what we paid for it we still have a large gain we which are continuing to defer. Can we use the carry forwards from the house we convert back into our primary residence to off set the gain from an ordinary (not 1031) sale of another real property?

As I mentioned, our income is going to really drop ($70k). With the write offs from our other properties I don't think we're going to have much in the way of taxable income for the next several years.

Your thoughts?

Thanks,

Bonnap

[rangerj]

Passive activity losses that are not deductible currently, due to limitation or lack of passive income, are freed up when the property that the expenses apply to is totally disposed of. You cannot apply the ordinary passive losses of one property to the capital gain of another property. If the property with the loss carryforward is totally disposed of (sold) then the passive losses associated with that property become ordinary losses, from whatever the passive activity is, say residential rental activity, used in the computation of taxable income for the year of the sale. Gain or loss on the sale of that property and any recapture also enter the total picture.
As stated earlier see a tax professional and PLAN your transaction to the best tax advantages.

[mwcpa]

I concur with rangerj..... generally losses on the property that are not deductible because they are passive can be used when that property is disposed of.... and 1031 can make things hairy when one "moves" back into the property....

the passive loss rules can be tricky and without seeing all of the facts it is a disservice to suggest what may or may not happen.... see a qualified tax professional to review all of the facts....

[Deleted]

Thanks for the clarification on the use of the carry forwards. Is there a time limit on how long they can be used?

For example, if we sell the asset (let's call the house in the 'forgot to depreciate" thread house #1) in 5 years when our income is in the $70k range I suspect that between the paper losses (depreciation) from the other properties, we might only need to use about 20k per year of the carry forwards. Do they expire?

"and 1031 can make things hairy when one "moves" back into the property...."

O.K. I'll bite and ask how it gets hairy and give you more details because you're right, it's a little more complicated with house #2.

In 2001 DH inherited a 1/2 interest in a little strip mall (technically an accessory retail center-think of the little strip of shops next to a grocery store but it didn't include the grocery store). He inherited via one of those irrvocable by-pass Trusts created by his grandmother so he did not get the benefit of the stepped up values of the Trust when his father died but inherited the Trust's assessed valuation of the assets. The death taxes were paid and the By-Pass Trust was created in 1971. In 1989 (at the height of the 80s real estate boom) the Trustees did a 1031 exchange from a vacant piece of property (valued in 1971 at $70,000) into the strip center. Purchase price was $1.6M with a $800k seller carry back 1st.

I don't think the center was ever a money maker. The center is located in the Inland Empire in So. Cal and there were never any national chain or credit tenants. There were some serious issues with the condition of the center and in short, the Trustees had no business buying an asset like that for a small Trust. When DFIL died and that half of the Trust dissolved we had the 1/2 interest in the center deeded to DH and me. I'll skip all the management and capital repair issues but finally at the end of 2004 we had an unsolicited offer to buy the center for $1.5M which I convinced the other half to accept. We did a 1031 of our half into a SFR in the San Diego area in January 2005 which we planned to live in at some point to be closer to my aging parents. (We did use the professional intermediary and our CA based CPA so I know it was done correctly). Acquisition price of the new property was $715k, debt $300k and we did pay a little cap gains tax on the boot because the price and debt were a little lower than the traded out property.

Fast forward to 2011. Now the property is worth about $600k on a good day. On the depreciation schedule of our taxes it looks like we are claiming $287K of depreciating capital assets plus a land value of $91,500 for a total capital value of $378,500 (I'm rounding numbers btw). Ending accumulated depreciation as of 2010 is $62k.

So if I learned my lesson from the other post and did a straight private sale today;

$62,000 carry forward * .30 = (18,600)

Cap gain is 600,000 - 378,500 = 221,500
less the $62,000 depreciation which is taxed at .25% = $15,500
=$159,500 * .15 = $23,925
Net $20,825 tax

Net would be in the $295k range depending on closing costs.

Now if we move into that house next year because we sold house #1 and live there for 5 years (2017) it gets interesting.
Is the date of ownership 2005? or an earlier 1031 date?

Assuming 2005 is the ownership year, my guess is that we would count the years 2009-2012 (4 years) as unqualified. And years 2005-2008 (4) and 2013-2017 (5) as qualified so we would be prorating the capital gain tax of $23,925 by 4/9 or .44 for a new capital gains tax owed of $10,527. We would still owe tax on the depreciation of $15,500, less whatever offset we would be allowed for the carry forwards with our lower income; maybe our rate will be .20 therefore -$12,400. So total tax would be in the $14k range.

Assuming property values and tax rates stay the same the net would be in the $305k range depending on closing costs. But a good portion of that extra net would be from loan principle paydown over 5 years since being in a lower tax bracket lowers the value of the carry forwards. It's a lot of hassle and risk for very little financial return. We should have a better reason to move in than to save $5k net on taxes because it will probably cost us that much to move our stuff!

[mwcpa]

the complication for 1031 is when one acquires a property in a 1031, then converts that home to a principal residence and then sells that home. one must own the property for 5 years in order to get the special exclusion under 121.....it seems you meet this rule.... (the rule came about when someone would flip appreciated rental property into new rental property, say a commercial building for a single family home, then a short time after the conversion kick out the tenants, move in and two year later sell the now principal residence potentially avoiding a large amount of tax. Congress closed that loop as it was seen as an abuse.

It is really hard in a forum like this to address the specific facts you lay out, which is why you will see Ranger and others like me give general direction only and simple examples of how things work....

[Deleted]

Thanks MWCPA.

Yes I was aware of the 5 year rule. When I read your comment I wanted to make sure I didn't miss something else. Going through the exercise was helpful. Given the drop in value and the changes in tax law it's pretty clear that it doesn't make sense to move in for tax reasons. It was a different story when prices had peaked in 2007 and we were looking at a possible capital gain in the $350k-$400k range.

We'll just have to see how things play out. My mom has since passed on but my dad is still in the area.

[mwcpa]

glad we (ranger and me, but I am sure others would have added if more was needed) were able to help.... happy turkey day, even though it'll be a German thanksgiving for you.....but beer and weiner schnitzel may be a good alternative to turkey and stuffing.....a few years back my wife and I were in Thailand for thanksgving and had pad thai and chicken in green curry ("thai spicy" of course)....

[rangerj]

Happy Thanksgiving folks. I'll add an additional thought to be considered when all the facts evolve. The loss that becomes deductible when the property is disposed of, other than any capital loss, may be a "net operating loss" and opens up the possibility of a carryback (2 years). Add this into the mix for planning purposes. Cheers.

[Deleted]

MWCPA,

Thanks for the Thanksgiving wishes; I hope yours was wonderful. We are celebrating on Saturday. Although there's still a large American presence in Germany we haven't convinced them yet that they need to adopt our holidays.

And don't feel sorry us. We're picking up our free range Turkey early Sat am (expensive as hell but worth it) and my husband will barbeque it in our U.S. imported Webber. Our military pals are bringing pumpkin pies made from ingredients picked up at the nearby military U.S. base. It's going to be fun!

[Deleted]

"The loss that becomes deductible when the property is disposed of, other than any capital loss, may be a "net operating loss" and opens up the possibility of a carryback (2 years)."

Hey Ranger, happy Thanksgiving to you too. Could you explain the term "carryback" as used in your post? Does that mean we have to use up the carry forwards within 2 years of disposing of the property?

Thanks,
Bonn ap

[mwcpa]

A NOL is possibly created when your business related "losses" exceed all other income.....
simple example....
you have a salary of 10
you have a self employed business loss of 30
you have no other items of income and you claim the standard deduction
you have "total income" and "adjusted gross income" of (20)
The 20 is known as an NOL, which is carried back unless you elect to carry it forward.

In your case bonn, since your overall capital gain on this property will be larger than the carry over losses that will be "freed" up upon disposition, an overall loss may not be created.... but, in the last couple of years I have had a few clients in the real estate business had losses that were able to carried back to offset income in prior years (in one case the loss was too big and even after carrying back he has a ton to carry forward.... Vegas real estate, love it)

[Deleted]

"A NOL is possibly created when your business related "losses" exceed all other income.....

Thanks MWCPA. Fingers crossed we don't get ourselves in THAT situation