Have you ever rented out a house that was a personal residence (or the opposite) and then sold it? Perhaps you’re thinking about doing this?
If your rental built up losses, you may be waiting for an opportunity to deduct the losses on your tax return. Since the rental was probably considered a passive activity under the tax rules, you need passive income to deduct the losses. The sting of this story is old news for those of us that dabble with rental properties. The alternative for deducting the losses, something else you may have heard, is to deduct the losses against gain on disposal of the property.
Then the irony sets in. If the property qualified as your primary residence (living there 2 out of the last 5 years), the gain may not be taxable anyway. This is referred to as the homesale exclusion. If qualified, a taxpayer can exclude up to $250,000 of gain, if single or $500,000 gain for married tax payers.
So suppose you do qualify for this exclusion. Will your non taxable gain on the sale of your personal residence, use up your passive loss carried forward from when it was a rental? What a bummer if true! You promised those rental losses from years past would lower your taxes someday but this theory could reduce or completely eliminate those losses without any reduction to your taxes.
Fortunately, recent advice from the IRS Chief Counsels office (CCA 201428008) says no way. The gain that isn’t taxable due to the using the homesale exclusion does not reduce your passive activity loss from that house. The IRS has concluded that you can preserve your passive loss carry-forwards for use against other income.
Please contact me if I can help you with questions about deducting losses related to your rental properties.