When you sell a rental property can you reduce previously reported depreciation in years that the depreciation is dis-allowed becasue of high income?

[ltc-tjrogers]

I sold a rental single family home. In previous years I was not allowed to take loss deductions for the rental since my income was above a level that those deductions would be allowed. When I enter the sales info the Loss I have experienced is reduced by the previously reported (Transferred in by TurboTax) depreciation. Is this correct, as it seems that since the depreciation was disallowed I should not have to include it in the “Previous depreciation”?

[view2]

Form 8582, which is used to calculate passive activity loss limitations.are carry forward until either the activity is disposed of, or passive gains arise to be offset.

Passive losses are generally deductible only to the extent of passive income. However, current and suspended losses are fully deductible if there is a “qualifying disposition.” Under IRC § 469(g), a “qualifying disposition” requires three criteria:

1. Disposition of an entire interest (or substantially all[1])

2. In a fully taxable event (where all gain/loss is realized and recognized).

3. To an unrelated party.

If these three tests are met, losses are fully deductible against non-passive income (unless the taxpayer has basis limitations). Thus, in the year of disposition, losses allocable to the passive activity may offset portfolio and other investment income or may become part of a net operating loss."

Depreciation recapture comes from the Taxpayer Relief Act of 1997, which imposed the higher tax rate for all IRC Section 1250 gains, which for means all rental property investments. When you sell the property, you must “recapture” any depreciation you've taken “allowed” (or could have taken “allowable”). ( The IRS will TAKE IT  even if you had not claimed the depreciation in earlier years)

[rwarfel]

"If these three tests are met, losses are fully deductible against non-passive income (unless the taxpayer has basis limitations)."  What are "basis limitations"?

[Kitty4]

If I take depreciation that has been carried forward on a 8582 in the year of disposition, won't it immediately be subject to recapture?  If so, it seems that I would not want to deduct the depreciation carry forward portion of 8582 carry forward expenses in the year of disposition, however, I would definitely want to take all the carry forward operating expenses. I can't find any clear guidance on what to do in this situation - appreciation your help! @view2 @ltc-tjrogers @rwarfel 

[Carl]

it seems that I would not want to deduct the depreciation carry forward portion of 8582 carry forward expenses in the year of disposition,

While it may seem that way, by law you don't have a choice. Depreciation is taken for the entire time the property is in service and classified as residential rental real estate. Basically, the depreciation taken in the year of sale is "cancelled out" as a part of the recapture. All recaptured depreciation is taxed at a minimum of 15% and a maximum of 25%.  So even if your other income is all in the 12% tax bracket, the recaptured depreciation is still taxed at the minimum 15%.

Additionally, all carry forward losses are also deductible in the year of sale. First, those losses are taken against any gain realized from the sale. If the losses exceed that gain, then the remaining losses can be taken against what is called you "other ordinary income". The loss against other ordinary income is only allowed in the year of the sale.

Usually your carry-forward losses allowed in the year of the sale tend to cancel out quite a bit of the recaptured depreciation, and sometimes even a bit of the taxable gain from the sale.