Discussion:Passive Losses When Section 121 Is Used

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Discussion Forum Index --> Tax Questions --> Passive Losses When Section 121 Is Used

Lmscpa (talk|edits) said:

10 February 2006

A client sold a home that had been rented out but still qualified for the Section 121 gain exclusion. He didn't qualify for the full exclusion since he had to move away within the 2 years. Since the move was job-related, he qualified for some of the exclusion. In rough numbers, the total amount of gain that he had on the property was $230,000. He was entitled to exclude almost $200,000 of that. His PAL on the property (and he has no other passive activities) is about $50,000. Can he deduct the full $50,000 passive activity losses in the year of sale or is he limited to only using the losses to offset the $30,000 gain taxable on the sale? If the latter is the case, what, if anything, can he do with the remaining PAL?

Riley2 (talk|edits) said:

10 February 2006
It depends on how you interpret the Sec. 469(g)(1)(A) fully taxable disposition rules and the term “If all the gain on the transaction is recognized”. In the transaction you described, was all the gain recognized? Some practitioners maintain that the all of the gain was indeed recognized, but a portion of the gain was excludible.

The term recognized gain is commonly understood to mean the portion of the gain that is not subject to deferral. If that interpretation is correct, the entire gain was indeed recognized, but a portion of the gain was excluded, and there would be a fully taxable disposition as described in Sec. 469(g).

PVVCPA (talk|edits) said:

February 24, 2007
PPC 1040 Deskbook says that suspended PAL's can only be freed up in a "fully taxable" transaction. And taking a Sec 121 exclusion is not a "fully taxable" transaction. So, therefore, the entire PAL will remain suspended.

I am wondering if PPC erred in their interpretation of Sec 469. Did it mean to say that the fully suspended PAL carryforward can only be freed up in a fully taxable transaction?

In other words, for Lmscpa's client, the fully suspended PAL of $50K cannot be freed up because the disposition was not a "fully taxable transaction". However, $30K of the $50K can be freed up.

PGattoCPA (talk|edits) said:

24 February 2007
We have a recent thread here: Discussion:Sale_of_Duplex_-_1/2_Personal_and_1/2_Rental

My position is that the practitioers Riley2 mentions above who "maintain that the all of the gain was indeed recognized, but a portion of the gain was excludible," equates with "fully taxable" are wrong. Why? Becasue as PVVCPA mentions above, the code says "fully taxable". An excluded gain is not "fully taxable". In fact, by the very nature of its exclusion the excluded portion is fully NOT taxable.

I say the suspended losses remain suspended unless the numbers pencil out and the client makes the §121(f) election to not exclude any of the gain because recognizing the ENTIRE gain and utilizing the suspended losses will result in a better tax answer.

Death&Taxes (talk|edits) said:

24 February 2007
There is a significant difference in the properties in that other discussion, which was in fact two separate properties separated by common wall. No such condition exists here and I would have to agree with Signore Gatto.

Riley2 (talk|edits) said:

4 March 2007
With all due respect to Mr. Gatto and PPC, the Tax Court has ruled on more than one occasion that the heading preceding a code subsection or paragraph cannot override the plain meaning of the language contained in the text of the code section. For example, see Richard D. Warren, et ux. v. Commissioner, 114 TC 343. The heading preceding Internal Revenue Code § 469(g)(1) reads “fully taxable transaction.” However, the text of that paragraph does not describe a “fully taxable transaction.” Instead, the text describes a transaction in which all “realized gain is recognized.” See TAM 9739004, RIA Checkpoint M-5707.

This provision effectively stops or defers the release of the suspended losses on all nonrecognition transactions. Nonrecognition transactions include transactions described in Code Sections 332, 351, 354, 355, 368, 721, 1031, 1032, 1033, 1034, 1035, 1036, 1041, and 1398 -- in other words, transfers of property resulting in gain deferral. However, unlike a Sec. 1034 sale of a residence, a Sec. 121 sale does not result in gain deferral -- merely a gain exclusion. In the case of a nonrecognition transaction, the suspended losses generally follow the replacement property.

The legislative history behind Sec. 469(g)(1) suggests that the reason for the “all realized gain is recognized” rule is that it would not be proper to release suspended passive losses at the time of a nonrecognition sale since the “taxpayer retains an interest in the activity, and hence has not realized the ultimate economic gain or loss on the investment in it……..” Thus, the Service reasoned that a taxpayer’s release of suspended passive losses would not be appropriate in a sale of a residence that qualified for gain deferral under old Sec. 1034 since Sec. 1034 is a nonrecognition provision and the taxpayer retains an interest in the new residence into which the gain from the sale of the old residence was deferred. See TAM 9739004.

Regulation Sec. 1.897-6T(a)(2) gives a brief discussion of the definition of a nonrecognition transaction, and Reg. 1.897-6T(a)(2) clearly states that a sale under Sec. 121 or Sec. 453 is not considered to be a nonrecognition transaction for purposes of Sec. 897(e). I have no reason to believe that the Treasury would come to a different conclusion when Reg. § 1.469-6 is issued (pending).

Solomon (talk|edits) said:

5 March 2007
Thanks Riley. Perhaps your analysis will put this topic to rest.

Birdman (talk|edits) said:

15 February 2011

Has anyone had additonal experience with this issue? (releasing PALs in a 121 sale - where it was formally a rental and now a residence). It seems that the IRS isn't specific to a 121 transaction, and the TD is also dragging with guidance with 1.469-6 or whatever else.

I read the below publication from the IRS. Although not authoritative, I can see both sides of the argument. When it discusses transactions that are not taxable, they do not refer to a 121 sale (I see this as support for releasing the PAL).

I was worried when I read that the sale had to be "of a passive activity", which a residence is not. But the actual code says (or former passive activity).

As an audit guide, they instruct the auditor to look for the gain reported on the tax return. I suppose that is possible in a 121 transaction by showing in and out.

With such a common occurance, why isn't there a definite answer?


Kevinh5 (talk|edits) said:

15 February 2011
Maybe one side backs down before tax court.

DaveFogel (talk|edits) said:

15 February 2011
I agree with Riley’s analysis above. According to the General Explanation of the Tax Reform Act of 1986, Joint Committee on Taxation, JCS 10-87 (May 7, 1987), p. 229, which you can download from http://www.jct.gov/publications.html?func=select&id=44, the types of transactions where Congress did not intend to release the suspended losses were nonrecognition transactions in which the taxpayer retained an interest in the property:

"An exchange of the taxpayer’s interest in an activity in a nonrecognition transaction, such as an exchange governed by sections 351, 721, or 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, e.g., in another like-kind activity), and hence has not realized the ultimate economic gain or loss on his investment in it."

Thus, for example, under the old IRC §1034, if the taxpayer purchased a replacement principal residence and as a result, there was nonrecognition of the gain, then the suspended passive losses would not have been triggered. But the nonrecognition-of-gain rules of IRC §1034 were replaced with the limited-exclusion rules of IRC §121. Therefore, I think that IRC §121 is not a "nonrecognition transaction" that would prevent the suspended losses from being released.

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