It is not unusual for someone to convert a personal home into a rental property. But such conversions can raise some complex tax questions when the home is subsequently sold.
Proper Tax Treatment
Under Internal Revenue Code Section 469, passive losses are generally deductible only to the extent of passive income. Rental real estate activities typically are deemed passive activities.
A passive activity loss (PAL) is the excess of your passive activity deductions over your passive activity gross income. Such “disallowed losses” are treated as a deduction allocable to passive activity in the next tax year — what is commonly known as a “suspended PAL.”
Sec. 469 also provides that suspended PALs are fully deductible against nonpassive income if there is a “qualifying disposition.” Such a disposition occurs when the taxpayer sells his or her entire interest in a passive activity to an unrelated party, and all gain or loss realized is recognized. In these circumstances, the excess of any loss from the activity over any net income from all other passive activities is treated as a loss that is not from a passive activity.
In a recent Chief Counsel Advice memo, the IRS weighed in on the proper tax treatment of suspended PALs from passive rental activity involving a taxpayer’s former principal residence when the property is sold for a gain. In addition to addressing Sec. 469, the IRS considered Sec. 121 of the Internal Revenue Code.
Under Sec. 121, a taxpayer can exclude from taxable income any gain from a sale or exchange of property that has been owned and used as the taxpayer’s principal residence for two or more years over the five-year period preceding the sale. The allowable exclusion is up to $250,000 in gain per taxpayer; married taxpayers filing jointly may exclude up to $500,000.
Scenario in Question
The Chief Counsel Advice described a scenario in which a taxpayer bought a principal residence for $700,000 and owned and used it as his principal residence for two years before converting it into a rental property. The related rental activity was the taxpayer’s only passive activity for purposes of Sec. 469.
During each year the property was rented, it produced $10,000 in suspended PALs. Within three years of renting the property, the taxpayer sold the property to an unrelated third party for $800,000, realizing a net gain of $100,000.
The gain was excluded under Sec. 121, but what about the suspended PALs? Did the use of the exclusion block the release of PALs upon the qualifying disposition? Not according to the IRS.
The agency held that, to the extent the suspended PALs exceeded any net income or gain from all other passive activities for the tax year of the sale, the losses should be treated as not from a passive activity. Because the $100,000 gain was excluded under Sec. 121, it was not part of passive activity income for purposes of Sec. 469, so the taxpayer had zero passive income or gain. Thus, the $30,000 was treated as a nonpassive loss that could be fully deducted.
Some Clarity from the IRS
The Memo makes it clear that the gain excluded under Sec. 121 is not treated as passive gain. It also confirms that the suspended PALs are “freed up” in the year of disposition.
Although this eliminates some of the uncertainty surrounding the interplay between Sec. 121 and Sec. 469, each situation is a little different. If you are considering a sale of a former primary residence that has been converted to a rental property, or have other questions, contact Jeff Newman at [email protected] or call him at 312.670.7444. Visit orba.com to learn more about our Real Estate Group.