Passive Losses Don’t Destroy Your Tax- Favored Capital Gains
Do you have rental properties or other businesses that create suspended passive losses?
Note. Your suspended passive losses are those losses that you were not able to deduct in prior years because of the passive loss rules.
When you dispose of your entire interest in a passive activity (or group of activities if grouped) in a fully taxable transaction, you release the suspended passive losses from that activity.
Say you have this situation:
$300,000 of long-term capital gain from the sale of your Pine Street rental property (this property is not grouped)
$100,000 of suspended passive losses from the Pine Street property
$200,000 of suspended passive losses from other rental properties How do you benefit from the sale of your Pine Street property?
Tax Attributes Don’t Change
The number one thing to know is that although any gain or loss from the disposition of a passive activity is passive, such gains or losses retain their tax characteristics.
The passive loss rules sometimes create taxpayer confusion over what happens when you make a total disposition of a passive activity. For example, the long-term capital gain from the total disposition of the Pine Street property creates passive income under the passive loss rules, but the gain retains its character as long-term capital gain, and it’s taxed at tax-favored long-term capital gains rates.
Passive activity losses come about when the losses from all passive activities for the taxable year exceed the aggregate income from all passive activities for such year. You carry passive activity losses forward until you can use them against passive income.
The passive loss rules found in IRC Section 469 are merely loss disallowance provisions, and as such they do not change the character of any gain or loss.
Let’s go back to your hypothetical Pine Street situation and see what happens under these rules:
On your $300,000 capital gain from the sale of your Pine Street rental property, you have both long-term capital gain and “un-recaptured Section 1250 gain”—and both types of gain receive tax-favored capital gains rates.
Your sale of the Pine Street property is a complete disposition of that property, and that complete disposition releases the $100,000 of suspended passive losses that are now fully allowed against all of your other income. This $100,000 of losses includes losses from this year.
You still have $200,000 of tax code–defined passive gain remaining from the sale of the Pine Street property, and that releases $200,000 of your suspended passive losses from your other rental properties. You take the suspended losses as ordinary losses against all your other income.
The passive loss rules do not change the character of any gains or losses.
When you sell a property, the character of your capital and ordinary gains doesn’t change, albeit those gains count as passive income that enable passive loss deductions.
If all or some portion of a capital gain is attributable to real property depreciation, you are taxed at the rates that apply to un-recaptured Section 1250 gain.
The release of your rental passive losses creates ordinary deductions that you apply against all other income.
You have choices. Pay tax, pay no tax, or pay tax at your own pace.
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The material discussed on this page is meant for general illustration and/or informational purposes only and is not to be construed as investment, tax, or legal advice. You must exercise your own independent professional judgment, recognizing that advice should not be based on unreasonable factual or legal assumptions or unreasonably rely upon representations of the client or others. Further, any advice you provide in connection with tax return preparation must comply in full with the requirements of IRS Circular 230.
 IRC Section 469(g)(1).
Reg. Section 1.469-2T(c)(2).
 IRC Section 469(d)(1).
 IRC Section 469; CCA 201312041.
Sourced with the help of the Bradford Tax Institute.