How do depreciation recapture and passive activity loss work when sell as primary residence?

[newlandlord123]

I bought a home in 2018 and lived there for 2.5 years. (During this time, I rented out a room for 1.5 years.)

Then I converted the entire home to rental and plan to sell in a few years.

After converting to rental, the rental income barely covers mortgage interest, property tax, insurance, HOA and maintenance. But I understand I have to take depreciation each year, which is very high due to high home price. And I will carry over passive activity loss due to deduction restriction with high income.

My question is, what will happen in the two scenarios below when I sell the property?

Scenario 1: sell within the 2 out of 5 year rule:

Q1: Am I still qualified for this rule, considering the 1.5 years' renting out a room? I did live in the property as primary residence for the entire 2.5 years after purchasing it.

Q2: How is cost base for the home determined? If cost base = purchase price + closing costs  + improvement - depreciation, what is the depreciation here? Is it equal to the depreciation on tax return or depreciation - passive activity loss? 

Q3: If I sell at gain using the cost base above, for depreciation recapture, will I be taxed at 25% for all the depreciation taken or will the depreciation be reduced by passive activity loss?

Q4: If I sell at loss using the cost base above, I don't need to pay any tax but also I do not get any tax benefit?

In the end, I did not get any tax benefit from the depreciation (due to low rental income and high home cost). And my depreciation will be huge due to high property value. But after a lot of research, it seems like I have to pay tax on the huge depreciation that I did not benefit from in previous years when selling under Sec 121. This will effectively extremely lower my rental income.

Scenario 2: sell as rental property:

I feel things are a lot more clear under this scenario. The passive activity loss can be used to increase the property's cost base to reduce gain (save tax owed) and increase loss (increase tax benefit under Sec 1231). But still appreciate if someone can provide more details about how cost base and tax are calculated when selling a rental property (with carryover passive activity loss) at gain/loss.

Really appreciate any insights here. I have done tons of research online and read IRS documents but still have a hard time understanding potential consequence in each scenario (especially the depreciation recapture and passive activity loss parts). I will definitely also talk to a CPA when tax season comes but want to be better prepared ahead. 

[AmeliesUncle · Accepted solution]

Passive losses are completely separate from the capital gain or loss.  They are two separate and independent things.

1)  Yes.   It was still your Principal Residence during those 1.5 years.

2) Passive losses are separate and allowed in full whether it is sold at a gain or loss.

3) Same answer as #2.

4)  Same answer as #2.  You are still allowed the Passive Losses, which effectively means you ARE benefitting from the depreciation from prior years.

If you don't meet the 2 out of 5 year rule, the same things apply.  You just don't get to exclude the gain.

[Carl]

Depreciation is recaptured and taxed in the year of sale. Period. The taxation of depreciation recapture is anywhere from a minimum of 0% to a maximum of 25%. Weather the sale includes the sale of property that qualifies for the "lived in 2 of last 5" rule or not, is irrelevant. Recaptured depreciation is taxable income no matter what.

The allocated value of the allocated rental portion of your primary residence must qualify under it's own merits for the "lived in 2 of last 5" rule.

Things get much more complicated when you have a house that was your primary residence, primary residence with a percentage rented out, and a full blown rental property all within the last 5 years prior to the closing date of your sale. Timing of the sale can really matter.

Just keep in mind that if you sell at a gain, recaptured depreciation is not excluded from taxation, no matter what.