Suspend PAL and cap gains

3 Replies

I'm seeking clarification on activation of suspended passive losses upon sale of rental property. Let's use the scenario where my suspended PAL exceeds capital gains upon asset disposition.  

Does the total suspended PAL offset my ordinary income, and then asset sale capital gain get taxed at my capital gain income bracket rate - or does the suspended PAL offset the capital gains first, and the left over PAL offset ordinary income? I understand that i'll need to account for depreciation recapture separately. 

To take this one step further, let's take another hypothetical where i have suspended PAL for an investment asset that I dispose and 1031 to defer cap gains and dep recapture. In this scenario does the suspended PAL offset ordinary income, or does the suspended PAL carry over to the replacement asset?

1) There are ordinary/W2/active income on one side. Lets call that the :( side.

2) And there is the happy side... passive income (syndications, passive partnerships ie medical/dentist offices) and passive losses (depreciation, bonus depreciation via cost segregations common in syndications). You can you passive losses to neutralize/eliminate passive income. Thats what this is the good side and why passive losses are called PALs too for passive activity losses.

So there is a barrier between 1) Active Income and 2) Passive Income above. You cannot offset passive losses (PALs) for active income. UNLESS you are are real estate professional status for tax designation purposes and able to create a "grouping/active participation". 


So when a deal is successful and sold (full cycle) what happens then?

All investors will have to pay back the depreciation recapture (losses taken throughout the hold) and capital gain (the big payout on the end which is sale minus cost basis). But don't despair because although this is the case when you look at it myopically, in reality most investors go into multiple deals accumulating 100s of thousands of passive activity losses in their first few years investing. Those losses do not go away, but they become suspended to be used to offset future passive income and sales/capital events like this in the future. When you exit a deal, what normally ends up happening (like Tom Brady keep winning more Super Bowls) is that you go into two more deals (with now double the amount of capital) and you will likely find that with those new K1s you could result in you having way more passive losses you began with If you can see where this is going... yes, experienced investors with a lot of capital deployed might have 500k-1M+ suspended passive losses and have not paid taxes in years and do not appear to pay taxes for years! (you can find how much suspended passive losses you currently have on your IRS Form 8582 - which your CPA is likely not giving to you and in that case you should get a new one)

PS - I am not an CPA or attorney but I became financially free doing this for myself after 10 years working as a w2 engineer :( and I am sick and tired of seeing highly educated and hard working professionals getting stuck in the rat race because we deserve financial freedom and the option to do more with it.

Originally posted by @Allan C. :

I'm seeking clarification on activation of suspended passive losses upon sale of rental property. Let's use the scenario where my suspended PAL exceeds capital gains upon asset disposition.  

Does the total suspended PAL offset my ordinary income, and then asset sale capital gain get taxed at my capital gain income bracket rate - or does the suspended PAL offset the capital gains first, and the left over PAL offset ordinary income? I understand that i'll need to account for depreciation recapture separately. 

To take this one step further, let's take another hypothetical where i have suspended PAL for an investment asset that I dispose and 1031 to defer cap gains and dep recapture. In this scenario does the suspended PAL offset ordinary income, or does the suspended PAL carry over to the replacement asset?

- Suspended PAL carries over when you do 1031 exchanges.

- Your suspended loss will first net with you activity on your sch E and any remaining will be released and offset your other income (capital and W-2 income). See detail below if you want. 


In reporting the complete disposition of a passive activity, its current-year income or loss is combined with prior-year suspended losses for the activity. If the net result is (1) an overall gain and the taxpayer has other passive activities, or (2) an overall loss and the taxpayer has net income or gain from other passive activities, the income and losses are posted to Worksheet 1, 2, or 3 of Form 8582. The overall loss from the disposed activity is nonpassive to the extent it exceeds net income and gains from other passive activities [IRC Sec. 469(g)(1)]. For this purpose, net passive income and net passive losses from all of the taxpayer's other passive activities should be netted before any excess passive income is applied against the current and suspended passive losses from the disposed activity (Ltr. Rul. 9742002). If combining current-year income or loss from the disposed activity with the activity's suspended losses results in (1) an overall gain or loss, and no other passive activities exist, or (2) an overall loss, and the taxpayer has a net loss from other passive activities, gain or loss from the activity is not posted to Form 8582; instead, the various components (i.e., capital versus ordinary gain/loss) are reported on the applicable forms (e.g., Schedule E or D, or Form 4797).