Sec. 121 gain exclusion does not offset suspended passive losses

Qualifying taxpayers who convert a principal residence to rental property and sell it can exclude gain under Sec. 121 without offsetting any passive losses carried forward. 

The IRS concluded in a Chief Counsel Advice memo (CCA) that excluded gain from the sale of a former principal residence that was converted to rental property is not an item of passive activity gross income and, as such, does not offset any suspended passive losses upon disposition of the property.

Under the scenario outlined in the CCA, after owning and using a home as a principal residence for at least two years, a taxpayer converts it into rental property. The property, the taxpayer’s only passive activity, generates nondeductible passive losses during the next three tax years. Each year’s passive loss is suspended and assigned to the following tax year. Within three years of the property’s conversion to rental property, it is sold at a gain that exceeds the suspended losses. The gain is excluded from gross income under Sec. 121(a).

Under Sec. 121, up to $250,000 for single taxpayers ($500,000 for a married couple filing jointly) of gain from the sale or exchange of a qualifying property may be excluded from gross income. The property must have been owned and used as the taxpayer’s principal residence for periods totaling at least two years during the five-year period ending on the date of the sale or exchange.

Under Sec. 469(g)(1)(A), when taxpayers sell their entire interest in a passive activity to an unrelated party and all realized gain or loss is recognized, any suspended losses from that activity are offset against any net income or gain for that year from all other passive activities, and any excess is treated as a loss from an activity that is not passive. Passive activity gross income for a tax year includes an item of gross income if and only if such income is from a passive activity.

Excluded Sec. 121 gain, however, is not an item of passive activity gross income, the IRS reasoned. Rather, it is gain that has been realized and recognized and excluded from gross income. Therefore, under the facts of the CCA, the excluded Sec. 121 gain is not netted against the suspended losses, and those losses upon disposition of the property are treated in full as not from a passive activity.

– CCA 201428008

By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota–Duluth.