If a taxpayer converts a personal residence to rental property, he can deduct expenses against rental income. The basis for depreciation is the lesser of the adjusted basis or fair market value at the date it is converted to rental property. If the taxpayer does not materially participate in and actively manage the property, the losses from rentals are treated as passive losses and cannot be deducted in the current year. They are suspended and carried forward and can offset rental income of future years but any resulting loss is not deductible and is carried forward.
If a taxpayer continues to have non deductible passive losses, they accumulate and can be offset against the gain on the sale of the property. If the gain on the sale exceeds the cumulative non deductible losses, a question arises as to whether the gain is taxable and if so, is it ordinary income or Section 1231 or capital gain.
The IRS recently ruled in a Chief Counsel Advice memo [CCA 201428008] that when a personal residence is converted to rental property, the gain on the sale in excess of suspended losses can be excluded under Section 121(a) (sale of personal residence). The excluded gain is not an element of passive gross income and does not offset any suspended passive losses when the property is sold.
Under Section 121(a), a gain up to $500,000 for married filing joint ($250,000 for single, head of household and married filing separate), can be excluded from gross income if the taxpayer(s) used the property as a principal residence for at least two years within a five year period ending on the date of sale and did not exclude a gain on the sale of any other personal residence within the prior two years. If a taxpayer does not meet the two-out-of five year rule, a reduced maximum exclusion is available if the sale was due to a change in place of employment, health reasons, or unforseen circumstances. Under Section 469(g)(1)(A), when an entire interest in a passive activity is sold to an unrelated party, and all realized gain or loss is recognized, any suspended losses from that activity are offset against any net income for that year from all other passive activities, but any excess loss is considered as non passive.
The situation resulting in the GCA memo, involved a taxpayer who lived in his personal residence for two years and then converted it to rental property at the beginning of the third year. During years three to five, the taxpayer had non deductible passive losses. At the beginning of In year six, the property was sold for a gain that exceeded the suspended passive losses. The IRS said that excluded Section 121 gain is not an item of passive income but is treated as realized gain excluded from gross income. As a result of the GCA, the gain excluded under Section 121 is not netted against the suspended losses, and the losses from selling the property are treated in full as non passive.