What happens to the passive loss carryovers from our rental property if we change the property from rental to our primary home?

[jenbenroth]

@AmeliesUncle thank you so much for the information. I had a follow up question for you or anyone else that may know the answer.  I qualify for section 121 capital gains exclusion and also have a PAL since the property was both a rental (2006-2017) and primary residence. (2003-2006, 2017-2020).

If I show the transaction as a “Sale of Home” under 121, then include the depreciation recapture can I still release my PAL?  Is this considered a “fully taxable transaction”, which is a requirement for recognizing the PAL?  You said” If it was converted to a personal residence, you do NOT report it in the "Sale of Business Property" section.  You report it as the "Sale of Home".”  Therefore I am working through if it makes more sense to report the sale as a “Sale of Home” with depreciation recapture or “Sale of Business Property” with a capital gain since it has a PAL that I want to recognize.  Thank you for for assistance!  I found this in regards to the home sale under section 121 and the PAL but want to be sure I interpret it correctly. Does it mean I can release the PAL when the  section 121 sale has excluded capital gains?  https://www.google.com/amp/s/www.taxwarriors.com/blog/bid/203125/pal-from-home-converted-to-rental-d...

[DianeW777]

Yes, you can take the passive activity losses (PALs) that have been suspended in two situations.

1. Against passive-activity income, OR
2. 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.  

• IRS Memo - IRC Sections 469(g) and 121

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]

[jenbenroth]

@DianeW777 Thank you. So since the PAL losses may not be written off in the year of disposition if I am excluding capital gain under IRC 121 it seems it is best that I treat the sale as a sale in rental property, calculating the gain on the sale in a fully taxable transaction and then I can recognize the PAL.   Agree?

If I were to exclude capital gains under 121 I end up paying taxes on depreciation recapture when in reality I never benefited from the depreciation in the past because I was subject to the passive losses. Paying capital gains tax on the full gain of the sale and recognizing the PAL seems to be more appropriate.

[AmeliesUncle]

You CAN use the Passive Loss Carryovers, even when using the §121 exclusion.  The §121 exclusion is NOT considered as a non-recognition event, and therefore the sale is still considered as a "fully taxable transaction".

https://www.irs.gov/pub/irs-wd/[social security number removed].pdf

[jenbenroth]

@AmeliesUncle Thank you so much for confirming.  That was what I thought when I read up on it but it is such a complex situation I wasn’t sure if I was interpreting it correctly.  In this situation is it better to report the PAL as negative other income or to do the Sch E workaround you mentioned earlier where you enter 15 days rented with no income or expense in order to generate the passive loss form?  Thank you!

[AmeliesUncle]

If you have other passive income or losses, use Schedule E.

If you don't have any other passive income or losses, both should have the same results.   I think I would do Schedule E just so it is more clear where the deduction is coming from, but the end result should be the same either way.

[jenbenroth]

@AmeliesUncle Thank you again.  Could you provide the IRS guidance # or how I can look it up?  The link you posted for the guidance goes to a "Page not found".  Thank you!

[jenbenroth]

@DianeW777 @AmeliesUncle I found this IRS Memo.  Based on this it is my understanding that I can recognize the PAL in the year of sale.  I do have other income for 2020 and Turbo Tax seems to be working properly by allowing the loss I entered in the Schedule E  passive loss carry over section, indicated I did not materially participate and that the property was sold, and it has labeled the loss NPA (non passive activity).  Also, the sale was to an unrelated party.  If either of you have additional information please let me know.  I really appreciated all the assistance.

https://www.irs.gov/pub/irs-wd/[social security number removed].pdf

In the CONCLUSION section: Gain excluded from gross income under § 121 of the Code is not an item of passive activity gross income for purposes of § 469. Therefore, the excluded gain does not offset suspended passive activity losses. To the extent that the losses from the rental activity, including the suspended passive activity losses, exceed any net income or gain for the taxable year of the disposition from all other passive activities, the losses will be treated as not from a passive activity.

In the ANALYSIS section:  a sale of a principal residence is a transfer of property for money consideration and, as such, gain realized on the sale is recognized in the year of the sale. Section 121 is simply an exclusion provision for gain that is realized and recognized in the year of sale. In these facts, because $100,000 of gain realized is recognized upon the sale of Individual A’s entire interest in a passive activity to an unrelated party, § 469(g)(1)(A) applies. Therefore, to the extent that that the suspended passive activity losses exceed any net income or gain for the taxable year of the disposition from all other passive activities, the $30,000 losses will be treated as not from a passive activity under § 469(g)(1)(A).

[jenbenroth]

@AmeliesUncle I figured out that for California I needed to reenter some information for the sale in the state area within TurboTax.  My state return is now picking up the loss.  thank you.

[presskh]

Thanks so much for the advice.  I have the same situation and have been pulling out my hair as to how to handle it.  I will use your method.