Does Schedule K-1 Box 11i capital gains count as passive income on Form 8582 when partnership sells property?

Your accountant is correct on this. Capital gains reported in Box 11i of Schedule K-1 are treated as portfolio income, not passive income, even though they come from a partnership where you're a limited partner. The IRS makes a distinction between regular operating income from the partnership (which would be passive for you as a limited partner) and capital gains from selling the underlying property (which are considered portfolio income). Portfolio income, including capital gains, interest, and dividends, cannot be used to offset passive activity losses on Form 8582. This is a frustrating situation that catches many real estate investors by surprise. Even though you're a passive investor in the partnership, the capital gain from selling the property doesn't qualify as passive income for offsetting your rental losses. You'll need to report the capital gain and pay taxes on it separately from your passive activity calculations.

After dealing with a similar situation last year, I discovered taxr.ai (https://taxr.ai) which really helped me understand these partnership K-1 issues. I was totally confused about passive vs. non-passive treatment on my K-1s from multiple real estate investments, and their document analysis feature cleared everything up. You upload your K-1s and other tax docs, and they explain exactly how each item should be treated and why. In my case, they confirmed what you're hearing about Box 11i gains, but also found some other items that WERE properly classified as passive, which my previous accountant had missed. They have tax pros who review everything and explain it in simple language without all the tax jargon.

Just wanted to update here. I tried taxr.ai after posting my question above, and it was seriously eye-opening. I uploaded my K-1s and they gave me a complete breakdown of how each box should be handled. They confirmed what everyone said about Box 11i gains being portfolio income rather than passive, but they also identified some other partnership items that WERE properly classified as passive income that I could use against my losses. They explained that while the capital gains from property sales aren't passive, certain income in Box 1 and Box 3 from my partnerships WAS passive and could be used on Form 8582. This completely changed my tax situation - I was able to utilize about $42,000 of my suspended passive losses this year instead of zero. Not as good as offsetting the full capital gain, but way better than nothing!

If you need to actually talk to someone at the IRS about this passive/non-passive classification (which is confusing as hell), try Claimyr (https://claimyr.com). I spent weeks trying to get through to the IRS to clarify some partnership rules after getting conflicting advice from two different accountants. Claimyr got me connected to an actual IRS agent in about 20 minutes when I had been trying for days on my own. They have this system that holds your place in the queue and calls you when an agent is about to answer. You can see how it works in their demo video: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed everything about the Box 11i treatment and explained exactly why it's considered portfolio income instead of passive income. They also walked me through some alternative strategies for utilizing my passive losses.

I have to eat my words. After posting my skeptical comment above, I decided to give Claimyr a shot since I was desperate for answers about my K-1 situation. Not only did it work, but I got connected to an IRS tax specialist who actually knew about partnership taxation. The agent confirmed everything about Box 11i capital gains being portfolio income rather than passive income. But here's the really valuable part - she explained that I might qualify for an exception based on my specific situation because part of my gain was related to unrealized receivables rather than purely capital assets. This potentially changes how some of my gain is classified. I would have never known this if I hadn't actually spoken to someone knowledgeable. Definitely worth it after months of frustration trying to get through on my own.

Another option to consider: If you have passive losses that you can't use against this gain, look at whether you can do a 1031 exchange with your portion of the proceeds. While the partnership itself may not be doing an exchange, sometimes individual partners can do their own exchanges with their distributed proceeds. This would defer the capital gain and kick the can down the road. You'd need to identify replacement property within 45 days and close within 180 days, so timing might be tight depending on when this sale happened.

I had this exact situation last year with a LP interest. One thing to check: see if you have any ordinary income recapture in Box 16 or 17 of your K-1 related to the property sale. Sometimes a portion of the gain is characterized as ordinary income recapture instead of capital gain, and this portion MIGHT be considered passive for Form 8582 purposes. In my case, about 15% of the total "gain" was actually depreciation recapture, and my tax advisor was able to treat that portion as passive income that could offset some of my passive losses.

Slightly off-topic, but since you mentioned carrying forward passive losses for years... don't forget that when you fully dispose of your entire interest in a passive activity, you get to use up all the suspended passive losses from that activity. This doesn't help with your current situation, but something to keep in mind for future planning. So if you have another rental property with suspended passive losses, selling that property would allow you to use all those losses in the year of sale (even against non-passive income).

This is a really common misconception that trips up a lot of real estate investors. The key thing to understand is that the IRS has three buckets of income: active, passive, and portfolio. Even though you're a limited partner (which normally makes your income passive), capital gains from asset sales fall into the portfolio bucket regardless of your participation level. Think of it this way: the partnership's day-to-day rental operations generate passive income for you as a limited partner, but when they sell the underlying asset, that sale generates portfolio income. It's the nature of the income itself, not just your level of participation, that determines the classification. One silver lining: make sure you're maximizing any other passive income you might have. Check if you have any other K-1s with passive income in boxes 1, 2, or 3 that you can use against those carried-forward losses. Also, as others mentioned, look carefully at any depreciation recapture amounts - those might have different treatment rules. It's frustrating, but this rule exists to prevent people from generating easy capital gains just to offset passive losses. The IRS wants to keep these income streams separate for policy reasons.