Yes, you can take the passive activity losses (PALs) that have been suspended in two situations.
- Against passive-activity income, OR
- When you dispose of the passive activity in a fully taxable transaction to an unrelated party.
When you convert rental property into a personal home.
And the rental home had suspended PALs. You can continue to deduct the suspended PALs from other passive income. If you have no other passive income, the suspended losses remain suspended.
IF IRC Section 121 applies and you have qualify for the home exclusion of gain, when you sell the property, you might qualify to exclude gain on the sale. Since this is not a fully taxable transaction you still won't be able to use the suspended PALs.
Passive activities include trade or business activities in which you don't materially participate, such as limited liability companies; or rental real estate activities. For more information see IRS Publication 925.
Based on your information it seems you do qualify for Section 121. The rules under Section 121 for home sale is as follows, which consist of use and ownership.
- In general, to qualify for the Section 121 exclusion, you must meet both the ownership test and the use test.
- You're eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you're not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.
@jenbenroth I agree with the information in the link you referenced and it is included here.
Based on the memo the depreciation recapture that creates taxable gain allows for the use of the suspended PAL on the return in this year of disposition/sale.
[Edited: 03/08/2021 | 6:09a PST]
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