This is part 4 of 5 in a series on Passive Activities. You can read the previous articles here: Part 1, Part 2, and Part 3.

Nothing, it seems, lasts forever, and it is likely there will come a time when you will dispose of your passive rental activity. When this occurs, there are a number of issues that arise. What happens to those suspended losses that were previously denied? What is adjusted basis? What is depreciation recapture? Is there a profit or a loss on the sale? How much tax will I pay?

We will attempt to clarify these issues in this article.

The suspended passive losses that had been denied, including any passive loss for the current year, may be deducted when the entire interest in the property is disposed of in a taxable transaction to an unrelated party. All gains, if any, must be recognized on the sale. The overall net loss is fully deductible to the extent the taxpayer has basis in the asset.

Note that one of the criteria requires the disposition be a fully taxable transaction. This excludes like-kind exchanges, conversions to personal use, gifts, transfers incident to divorce, transfer due to death, and dispositions to related parties. Involuntary dispositions and foreclosures may qualify.

If the gain is excluded due to prior use as a primary residence under Sec 121, IRS Chief Counsel has ruled the sale a fully taxable event despite the Sec 121 exclusion and passive losses incurred during the rental period may be deducted. For example, assume that a property was used as a primary residence for two years, then converted to rental use for another two years. The house was sold for a $100,000 gain. At least some of this gain can be excluded under Sec 121. The exclusion of gain does not exclude the sale from being a “taxable transaction.”

Basis to determine gain or loss on the sale begins with the original purchase price or other basis if applicable. Basis is increased for capital improvements such as a new room and decreased for depreciation “allowed or allowable.” “Allowed or allowable” is IRS-speak for saying basis will be reduced for depreciation whether it was taken or not. These changes give you adjusted basis.

Depreciation recapture is an equalizing concept. While the rental was in use depreciation was deducted against income with the profit being taxed at ordinary income rates. When the property is sold, gain up to the amount of depreciation allowed or allowable is taxed at ordinary rates.

Profit or loss on the sale is simply the difference in the sale price minus costs of sale and the adjusted basis. Note that the payoff amount of any mortgage is not factored into gain or loss. That amount of gain represented by depreciation recapture will be taxed at ordinary income rates, which are between 10 and 39.6 percent for individuals. Any remaining gain may be taxed at capital gain rates, which are between zero and 20 percent. In addition, the taxpayer may be subject to the 3.8 percent net investment income tax enacted under the Affordable Care Act.

Obviously, there are a number of variables involved which get into more detailed situations than could be covered in this overview. As TV commercials frequently tell us, “Don’t do that his at home.” It is money well spent to consult with a qualified tax preparer before entering into such transactions.