Can passive activity losses offset depreciation recapture?
Passive activity losses that were not deductible in previous years have become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax.
Depreciation recapture on real property is nothing more than a specially taxed type of capital gain. As such, it can be offset by capital losses. Real property used in a trade or business or held out for rental is subject to an allowance for depreciation.
Key Takeaways. Passive activity loss rules are a set of IRS rules stating that passive losses can be used only to offset passive income. A passive activity is one wherein the taxpayer did not materially participate in its ongoing operation during the year in question.
Passive losses on the property that you still have are not "unsuspended" until you dispose of the property. You can use these losses to offset other passive income (i.e. Schedule E income, perhaps some Partnership income), but you cannot use it to offset the capital gain.
Investors may avoid paying tax on depreciation recapture by turning a rental property into a primary residence or conducting a 1031 tax deferred exchange. When an investor passes away and rental property is inherited, the property basis is stepped-up and the heirs pay no tax on depreciation recapture or capital gains.
Deducting Suspended Losses When You Sell Property
The tax rules provide that you may deduct your suspended passive losses from the profit you earn when you sell your rental property. To take this deduction, you must sell "substantially all" of your rental activity.
Can those passive losses be used to offset the depreciation recapture tax? The suspended passive losses cannot be used to offset depreciation recapture. But you can fully deduct these suspended passive losses when you sell your rental property in a qualifying disposition.
- You own an interest in the trade or business activity during the year.
- The rental property was used mainly in that trade or business activity during the current year, or during at least 2 of the 5 preceding tax years.
A capital loss is generated when a rental property is sold for less than the cost basis. Capital loss from one asset can be used to offset capital gains from the sale of another asset, and used as a deduction from ordinary income, with any unused capital loss carried forward to future years.
Depending on the underlying investment, some capital gains or losses can also be considered passive income.
What happens if a taxpayer is not able to claim losses from passive activities in the current tax year are these losses gone for good?
If your client can't deduct a passive loss for the tax year because they have not earned enough passive income to offset it, the loss can be carried forward until it is used or until the investment responsible for generating the loss is sold. The loss cannot, however, be carried back and applied to prior tax years.
Because you can deduct passive losses only from passive income, not from income from other sources such as earnings from a job or a business you actively manage. In addition, passive income does not include investment or dividend income.
One of the best ways is to use a 1031 exchange, which references Section 1031 of the IRS tax code. This may help you avoid depreciation recapture and any capital gains taxes that might apply.
However, keep in mind that even if you lose money on the sale you've still benefited by being able to use the depreciation deduction of $36,360 over the past 10 years to reduce your taxable income. The IRS also allows you to carry back the loss from a rental property by amending your previous tax returns.
| Federal Income Tax Items | 2021 | 2022 |
|---|---|---|
| Federal tax rate on the portion of long-term gain from real estate that represents depreciation recapture (so-called “Section 1250 gain”) | 25% | 25% |
| Federal tax rate on long-term gain from collectibles (e.g., art, antiques, precious metals, gems, stamps, coins, etc.) | 28% | 28% |
Gains from the sale of rental property are taxed as capital gains, but a loss on sale of rental property is considered an “ordinary loss.” Typically, the IRS allows you to carry forward a loss if you don't have gains to offset that loss at year's end, and you can claim up to $3,000 worth of losses against your other ...
Real estate investors use the depreciation expense to reduce taxable net income during the time they own a rental property. When the property is sold, the total depreciation expense claimed is taxed as regular income up to a rate of 25%.
If you sell your investment property for more than what you paid (i.e. making a profit), you've made a capital gain. In this case, your gain will likely be taxed. If you make a capital loss, you won't have to pay capital gains tax (CGT) and the loss can be used to offset future capital gains.
Passive activity losses that were not deductible in previous years have become fully deductible when a rental property is sold. This can help offset the tax bite of the depreciation recapture tax.
What Assets Are Subject to Depreciation Recapture? Depreciation recapture can apply to any depreciable assets for which you've received tax deductions in the past. The mechanism particularly applies to real estate investors who have made long-term capital gains on a rental property or investment property.
Do you pay both capital gains and depreciation recapture?
A capital gains tax applies to depreciation recapture that involves real estate and properties. The depreciation recapture for equipment and other assets, however, doesn't include capital gains tax.
Depreciation does not offset the gain; it can actually increase the amount of capital gains realized on the sale of property.
