PASSIVE ACTIVITY LOSS - Recover at Disposition

[FSC]

Have a client who sold residential rental property. Property is out of state, was not installment sale, taxpayer is not a real estate professional, and used a 3rd party rental company to manage rentals and take care of maintenance, etc. Taxpayer financed 90%, and had high int rate loan that bank refused to modify to lower rate. Mortgage payments greatly exceeded rental income that resulted in significant Schedule E losses that were not allowed because of other income.
Cost was $650,000; sell price after exp was $750,000; accum depreciation was $200,000 and prior years’ disallowed passive activity losses totaled $655,000.

1. Since this is complete disposition, taxpayer should be able to recover all of the $655,000 PAL. Correct?
2. This rental prop is Sec 1250, so report $300,000 gain on Form 4797- Part III? ($650 - $200 = $450 … and $750 SP – $450 Adj Basis = $300,000 Schedule D long term cap gain). All depreciation was SL so none of the gain is at ordinary income rate.
3. Finally, on Schedule E taxpayer can report 100% of current year rental loss and all previously disallowed passive active losses as per Form 8582.
I’m only concerned that I’m correctly reporting the big numbers here! Have some other Sec 1245 furniture and appliance reportings but those are immaterial.
Thanks for your help.

[Roland Slugg]

You have it pretty much correct, but let me clarify a couple things:

The disposition triggers the release of all accumulated PAL carryovers related to the activity (i.e. property) sold, which you say amount to $655k. That amount is deductible in full in the year the property is sold, as well as the current year's PAL, if any.

Yes, the gain on the sale is, a §1231 gain, resulting in a LTCG. $200k of that gain, however, equal to the depreciation taken over the years, is classified as "Unrecaptured Section 1250 Gain" and may be taxed as ordinary income but at a tax rate no higher than 25%.

In your post you made the following statement:

Mortgage payments greatly exceeded rental income that resulted in significant Schedule E losses.

I hope the taxpayer wasn't deducting the principal portion of the mortgage payments.

You mentioned that there is some furniture, albeit immaterial, which I gather was left with the property. I assume the buy/sell agreement did not allocate any part of the SP to that. Here's how I usually handle that: Add the cost and depreciation of the F&F to the cost and accumulated depreciation of the real property. This reduces the gain on the real estate by the remaining basis of the F&F. (It's the same result you would get if you allocated a portion of the SP to the F&F, in an amount equal to the F&F's basis at time of sale.) As an alternative, you can report the disposition of the F&F (on F-4797), showing a SP of $0, thus creating a "loss" on its disposition equal to its basis at the time of sale. This, however, could raise the question of an allocation, so I prefer the "grouping" approach.

I found your accumulated PAL total of $655k very hard to believe. Assuming a land value of, say, $50k of the property's original cost of $650k, that leaves a depreciable basis for the house of $600k. Accumulated depreciation is $200k, which means the property was owned for about nine years. This means that in order to accumulate $655k in losses, there would have to be an average loss of $73k per hear. I don't believe it. If I were the IRS, I would audit that taxpayer's returns, including the return for the year of sale, and I would expect to find significant amounts of add-backs and disallowances.

[TaxGuyBill]

I found your accumulated PAL total of $655k very hard to believe.

I agree, that much of a PAL carryover seems extremely high.

If you think it is correct, I would recommend making sure that everything is well documented, including that the rental price was at the Fair Market Value.

[buzzardbreath]

Accumulated Loss is quite possible

I had a situation a couple years ago where passive losses accumulated to a number otherwise suspicious. And there were reasons, some of which might not be defensible.

Firstly, the owner bought the home in anticipation of a commercial zoning, which never happened, even though the residence was next door to a strip mall. He bought it as an investment instead of for rental. I told him I could not deduct operating expenses unless he rented it out, so he began renting it reluctantly.

Renters were frequent, and many didn't stay long. Seemingly, huge repairs and cleaning were necessary every time a renter left. Revenue was not what anyone would expect, and expenses were huge.

In short, the owner did not buy this property to rent, and managed it very poorly. Still, there was enough effort to rent that I continued to accumulate losses. Not in the $600,000 range, but proportionately every bit as bad. Initial cost was $65,000 and accumulated passive losses were appx $80,000 over a 20 yr period.

[FSC]

Thanks for the replies. Unfortunately the PAL is correct. Have documentation for all expenses. Prop is in Outer Banks, NC and has limited peak rental months because peninsula is desolate in the winter and fall is hurricane season. Making things worse is the over abundance of available rentals and foreclosures.Also had interest only mortgage with negative amortization so prin loan bal is up to $825,000 (at 7%). Investment prop is now 13 years old, so yes, the losses are correct.
Just a very poor and costly investment decision.