Homeowners Can Take Home Sale Exclusion and Still Retain Suspended Passive Losses

In a big victory for homeowners (especially landlord/homeowners), the IRS says that you don't have to offset suspended passive losses from any profit excluded under the $250,000/$500,000 tax exclusion.

During the recent recession, many homeowners were unable to sell their homes and ended up renting them out instead. Now that market conditions have improved, many of these involuntary landlords are selling their property. A new ruling by the IRS could prove a boon to the many such homeowners who rented out their homes at a loss.

The Tax Rules

The ruling concerns the interaction of two complex tax rules: (1) tax exclusion for the sale of personal residences, and (2) the passive loss rules.

Home Sale Tax Exclusion

The home sale tax exclusion is a great tax break for homeowners. If you qualify, when you sell your home you don’t have to pay any income tax on up to $250,000 of the gain from the sale of your principal residence if you’re single, or up to $500,000 if you’re married and file a joint return. To qualify for the exclusion, you must own and occupy the home as your principal residence for at least two years out of the five years before you sell it. You can rent out your home for up to three years and still qualify for this exclusion. But, to qualify for the full exclusion, you must live in the house before you switch it to rental use.

Passive Loss Rules

Unfortunately, many homeowners who end up renting out their homes do so at a loss because the rental income their property generates is less than their annual expenses. Such rental losses are passive losses for tax purposes. Landlords whose incomes exceed $150,000 are able to deduct such losses only from other passive income they have, such as income from profitable rentals but not other nonpassive income such as salary or investment income.

Rental property passive losses you aren’t allowed to deduct in the year they are incurred are called suspended passive losses. They are not lost. Rather, they are carried forward indefinitely until either of two things happen: you have rental income, or you sell the property. You may deduct your suspended passive losses from the profit you earn when you sell your entire interest in your rental property to an unrelated third party. Any losses left over are treated as nonpassive losses that may be deducted from nonpassive income including salary and investment income.

The Facts

The IRS was presented with the following facts: An individual buys a principal residence for $700,000 and lives in it for two years before converting it into a rental property. He rents it out for three years. Each year, he incurs $10,000 in losses that are passive losses that he is unable to deduct because he has no offsetting passive income. Thus, he has $30,000 in suspended passive losses. He then sells the property for $800,000, realizing a net gain on the sale of $100,000 (not taking into account the $30,000 suspended passive losses). He qualifies for the $250,000 home sale exclusion.

The Legal Question

Here’s the question: What does the homeowner do with his $30,000 in suspended losses? Do they in effect get swallowed up by the $250,000 home sale tax exclusion? Or are they unaffected by the exclusion? This is no idle question, because if they remain after the exclusion, he can deduct them from his other income, both passive and nonpassive—in other words, he gets to deduct $30,000.

The IRS Ruling

In a big victory for homeowners who become landlords, the IRS says that a homeowner who has suspended passive losses does not have to offset them from the amount of home sale profit excluded from income under the $250,000/$500,000 tax exclusion. The homeowner gets to take advantage of the $250,000/$500,000 home sale tax exclusion, and may also fully deduct any suspended passive losses. (Chief Counsel Advice Memo 201428008(7/11/2014.)

So the homeowner in our example pays no tax on his $100,000 profit from his home sale. In addition, he may deduct his $30,000 in suspended passive losses from all of his income. If he was in the 33% tax bracket, this would save him $10,000 on his federal income taxes for the year.

The moral of the story: Be sure to keep track of all your rental expenses when you rent out your home. Even if you can't currently deduct them because of the passive loss rules, you'll be able to deduct them when you sell the home.

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