<<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 thededuction 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 afully taxable transaction (S. Rep. 313, 99th Cong., 2d Sess. 725 (1986)),any fully taxable transaction (e.g., an abandonment that would give riseto a deduction under Code Section 165(a) (H.R. Rep. 841, 99th Cong., 2dSess. II-143-44 (1986)) can qualify. On the other hand, an exchange of ataxpayer's interest in an activity in a non-recognition transaction (suchas a transfer of property to a corporation under Code Section 351, atransfer of property to a partnership under Code Section 721, or alike- kind exchange under Code Section 1031 in which no gain or loss is recognized) does not trigger suspended losses. Following such anexchange, the taxpayer retains an interest in the activity (or in anotherlike-kind activity) and, hence, has not realized the ultimate economicgain 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 thetransaction (e.g., boot in an otherwise tax-free exchange), the gain istreated as passive activity income, against which passive losses may bededucted.But...you may have some good news. Any losses not deducted because the disposition was not fully taxablecontinue to be treated as passive activity losses. S. Rep. 313, 99thCong., 2d Sess. 727 (1986). In some circumstances, however, they may bededucted against income from the property received in the exchange that isattributable to the original activity (but not income attributable toother activities). However, this rule does not apply to permit thededuction of suspended passive losses against dividends or other portfolioincome. S. Rep. 313, 99th Cong., 2d Sess. 727, n. 13 (1986). In addition,following some transactions, such as a Code Section 1031 like- kindexchange, the taxpayer may no longer have an interest in the originalactivity. There is no special rule permitting suspended losses from theprior interest to be offset by income from the new activity, unless it toois 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.TMF TaxesRoy
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