Can Suspended Passive Losses offset depreciation recapture (Home converted from Main home to rental)

[1040HS]

My wife and I (married filing jointly) purchased a condo in 2015 and used as primary residence for 2.5 years. In January 2018 this was converted to a rental and rented all of 2018 and 2019. During those 2 years the condo was depreciated by a total of $36,000. Also in each of those 2 years I had a $10,000 suspended loss on the rental ($20,000 total suspended loss). In early 2020 I sold the condo for a total gain of $80,000. Now I understand that $44,000 of that gain is not-taxable due to the sale of primary residence exemption.  The $36,000 is taxable as depreciation recapture. This is where I am up to and agree with on my current filing with TT.  Now I see the $36,000 gain on my Schedule D, which is flowing to line 7 on my 1040. However I also see the the carryover passive loss of $20,000 from Schedule 1 being carried over onto line 8 of my 1040 lowering my taxable income. 

I thought that carryover rental passive loss should not lower depreciation recapture, so I am worried that I should not be getting this $20,000 subtraction from my taxable income. Everywhere that I've researched it states that carrover passive loss cannot offset depreciation recapture. Should this carryover passive rental loss by on my 1040 and thus lowering my taxable income? 

[ColeenD3 · Accepted solution]

You're not applying it against the depreciation per se. The IRS states, "Generally, you may deduct in full any previously disallowed passive activity loss in the year you dispose of your entire interest in the activity.

Also, PALs not allowed in the current year are carried forward until they’re allowed either against passive activity income; against the special allowance, if applicable; or when you sell or exchange your entire interest in the activity in a fully taxable transaction to an unrelated party. 

A fully taxable transaction is a disposition in which you recognize all realized gain or loss.

Form 8582

[1040HS]

Ah, I see what your saying that it isn't offsetting the depreciation recapture per se. Thank you for that answer @ColeenD3 .

To follow-up and clarify - So even though the only activity flowing through my return this year are income from wages and the $36,000 depreciation recapture, it is still OK to deduct the full $20,000 of PAL against my total income in the current year (year of sale)? (Even if I do not have any other Passive activity gains)

[ColeenD3]

Correct. The law allows you to take it when you sell or exchange your entire interest in the activity in a fully taxable transaction to an unrelated party. 

[1040HS]

Thank you @ColeenD3 

Lastly I just wanted to confirm if the sale is considered a "fully taxable" transaction even though it was given the sale-of-primary-residence exemption due to us living in it for the first 2.5 years. So we were exempt from paying taxes on the capital gains part. Does that still make it a "fully taxable" transaction?

[ColeenD3]

You are confusing tax terms. It was a fully taxable transaction. The next step was that the gain was excludable. It is not exempt.

[nettestars]

I am in a similar situation.  We lived in a condo, then starting 2018 rented it out for 2.5 years , and now sold it (2021).  I made around 100k on the sale which will be excluded from tax.  To be clears the PALs accumulated over the 2.5 years (15k) can be used against the depreciation recapture (50K)?

[ThomasM125]

For the most part, you are correct, the passive loss carryovers are available to negate ordinary income that may occur due to depreciation recapture.

The unused passive losses are used to reduce ordinary income in the current year. Depreciation is recaptured as ordinary income to the extent you have a gain on the sale of the property. So, indirectly the loss carryovers can be used against depreciation recaptured, since they are both ordinary income/loss.

@nettestars