Managing Passive Losses and Maximizing Tax Benefits
A client recently approached me about selling a condominium in Chicago. This situation often confuses taxpayers because, while the property generated positive cash flow, it showed a loss on Schedule E for tax purposes. The case involved accumulated disallowed passive losses and the potential need to recapture accumulated depreciation. Here’s a breakdown:
Purchase Details
The client bought the rental property for $680,000 with a $590,000 mortgage. Over seven years, they claimed $25,000 per year in depreciation, totaling $175,000. Additionally, the property reported a total passive loss of $33,000 per year, amounting to a cumulative $231,000 loss over seven years.
Sale of Property
The client sold the condo for $720,000 and paid off the $350,000 mortgage.
Calculating the Realized Gain/Loss
To determine the long-term capital gain:
First, subtract the accumulated depreciation of $175,000 from the original cost of $680,000, resulting in an adjusted basis of $505,000. Then, with a sale price of $720,000, the client realizes a long-term capital gain of $215,000.
Because this gain was the only one for the year, $175,000 will be taxed at a maximum 25% rate due to the required depreciation recapture.
Handling Passive Losses
The sale “unlocks” these passive losses, allowing them to be used as ordinary losses in the year of sale. While these losses don’t reduce long-term capital gains, they offset ordinary earned income from the client’s W2 for that year.
Addressing Excess Ordinary Losses
If the ordinary loss exceeds the client’s income, the excess becomes a Net Operating Loss (NOL) that can be carried forward indefinitely.
For expert tax advice and to discuss your specific situation, contact us today! We’re ready to assist with all your tax needs.
