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<<Taxpayer had lived in his personal residence for 2 out of 5 years and qualified to exclude his gain ($250,000) using
section 121.

Taxpayer rented his house for 2 years before selling the house. Incurring $40,000 of loss carryovers because his
income exceeded $150,000.

Need more facts>>

Ditto...I would say the same. I would need a few more facts. But, assuming that I understand the issues...and assuming that I agree that the taxpayer is allowed the exclusion, I would also be curious what code section IRS is using to deny the prior passive losses. Just because they say you can't do something, it don't make it so.

But my guess is that the IRS is ruling that the sale of the personal residence, using the exclusion in code section 121 is not a "taxable transaction". And the passive loss rules are clear: in order to free up prior suspended losses, the disposition must take place in the form of a "taxable transaction". Code section 469(g) says so...clearly.

A disposition must occur in a fully taxable transaction to permit the
deduction of all losses from a passive activity. Code Section 469(g)(1).
While an arm's length sale to a third party is the clearest example of a
fully taxable transaction (S. Rep. 313, 99th Cong., 2d Sess. 725 (1986)),
any fully taxable transaction (e.g., an abandonment that would give rise
to a deduction under Code Section 165(a) (H.R. Rep. 841, 99th Cong., 2d
Sess. II-143-44 (1986)) can qualify. On the other hand, an exchange of a
taxpayer's interest in an activity in a non-recognition transaction (such
as a transfer of property to a corporation under Code Section 351, a
transfer of property to a partnership under Code Section 721, or a
like- kind exchange under Code Section 1031 in which no gain or
loss is recognized) does not trigger suspended losses. Following such an
exchange, the taxpayer retains an interest in the activity (or in another
like-kind activity) and, hence, has not realized the ultimate economic
gain or loss on her investment in it. S. Rep. 313, 99th Cong., 2d Sess.
726-727 (1986). To the extent the taxpayer does recognize gain in the
transaction (e.g., boot in an otherwise tax-free exchange), the gain is
treated as passive activity income, against which passive losses may be
deducted. may have some good news. Any losses not deducted because the disposition was not fully taxable
continue to be treated as passive activity losses. S. Rep. 313, 99th
Cong., 2d Sess. 727 (1986). In some circumstances, however, they may be
deducted against income from the property received in the exchange that is
attributable to the original activity (but not income attributable to
other activities). However, this rule does not apply to permit the
deduction of suspended passive losses against dividends or other portfolio
income. S. Rep. 313, 99th Cong., 2d Sess. 727, n. 13 (1986). In addition,
following some transactions, such as a Code Section 1031 like- kind
exchange, the taxpayer may no longer have an interest in the original
activity. There is no special rule permitting suspended losses from the
prior interest to be offset by income from the new activity, unless it too
is a passive activity.

But you really need to do some deep digging in the code to see how your specific situation fits the general rules that I provide here.

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