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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.

In the year of sale the taxpayer excluded the gain and accelerated the $40,000 of passive loss carryovers because he disposed of his residence.

The IRS now wants to deny the $40,000 passive loss using section 469 to offset the loss by the gain not recognized.

The tax forms do not tax the income under section 121 so how can the IRS offset the passive loss? The tax forms also allow the loss because the income never is shown on form 8582.

Does anyone have a case or cite to support my position for the taxpayer?

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