Tax implications when selling rental property with carry forward passive losses - impact on depreciation recapture? Official IRS rules?

Thanks for the info, but I'm still confused on the sequencing. Do the passive losses offset the depreciation recapture amounts first, or do they offset other gains first? Also, does it matter that some of our passive losses came from years where we were partially active in managing the property vs completely passive?

The passive losses offset the total gain, regardless of how that gain is characterized. There's no specific sequencing where losses offset one type of gain before another - they reduce your overall gain from the property sale. Regarding your second question, it doesn't matter if you were actively managing the property in some years versus others. What matters is whether your income from the activity was classified as passive under IRS rules. If you materially participated based on IRS criteria (generally more than 500 hours per year in the activity), it might not have been classified as passive to begin with. However, if these losses were properly characterized as passive and carried forward on previous Form 8582s, then they'll be treated the same regardless of your level of involvement in different years.

How exactly does this taxr.ai thing work? Do you just upload your tax documents and it spits out an answer? I'm always skeptical about putting my tax info on random websites. Is it actually accurate?

Does it tell you how to fill out the specific forms? I'm fine with calculating the numbers but I never know which boxes to put them in on all those IRS forms, especially for rental property sales where there seem to be a dozen different forms involved.

It's pretty straightforward - you upload PDFs of your previous tax returns or other tax documents, and it uses AI to extract and analyze the information. It's secure and doesn't store your documents after analysis. I was hesitant at first too, but they explain their security measures on the site. For the forms question, yes it actually does help with that. It showed me exactly which forms I needed (Form 4797, Schedule D, and Form 8582 in my case) and explained where each number needed to go. It even pointed out that I needed to check a specific box on Form 4797 to properly report the suspended passive loss release. I would have definitely missed that without the guidance.

Wait, there's actually a way to get through to the IRS without wasting your entire day on hold? How much did this service cost? Seems too good to be true considering I've spent literal hours trying to get through to them.

I'm skeptical... did you really get specific tax advice from an IRS agent? I've always heard they won't actually give definitive tax advice and just point you to publications. Did they really talk about your specific situation and give you a clear answer?

There's no set price I can discuss here, but you can check their website for current rates. It's worth every penny though - I was connected to an IRS agent in about 35 minutes instead of the 3+ hours I had been waiting before. Yes, I actually did get specific guidance! You're right that they sometimes just point to publications, but I asked very specific questions about which form to use for reporting the passive loss offset against depreciation recapture. The agent walked me through exactly which line items to use on Form 4797 and Form 8582. She even explained that I needed to check the box in Part I of Form 8582 that indicates I disposed of my entire interest in a passive activity. This wasn't generic advice - it was specific to my situation with passive losses offsetting depreciation recapture.

Good point about state taxes. I'm in New Jersey and found out they don't follow the same passive loss rules as the feds. Could you share any resources about figuring out the state-specific rules? My accountant seems confused about it too.

For state-specific rules, your best bet is to go directly to your state's department of taxation website. They usually have publications that outline where their tax code differs from federal. For New Jersey specifically, look at the NJ-1040 instructions, particularly the section on "Net Gains or Income from Disposition of Property" and any supplemental information about rental properties. Sometimes states publish comparison charts showing federal vs. state treatment of various income types. If your accountant is confused, it might be worth consulting with a tax professional who specializes in state-specific issues, particularly if you have a substantial amount of passive losses at stake.

I used TurboTax Premier last year for a similar situation. It handled it okay, but you need to make sure you enter everything in the right sequence. The interview questions about "disposing of a passive activity" are pretty buried in the rental property section. I recommend having all your past Schedule E forms handy when you do it.

This is exactly the kind of official guidance I was looking for! Thank you for citing the specific IRC section and publication. I've been struggling to find these exact references. Quick follow-up question - when you mention making sure the losses were "properly reported as passive on previous Form 8582s," how can I verify this? Should I be looking at a specific line or box on my old returns? I want to make sure I don't run into any issues when I file this year's return with the property sale.

To verify your losses were properly reported as passive, look at your previous Form 8582s (Passive Activity Loss Limitations). On Part I of Form 8582, check if your rental property losses were included in the passive activity loss calculations. The losses should appear in columns (a), (b), and (c) for the respective activities, and any suspended amounts should be carried forward to subsequent years. You can also check your Schedule E (Supplemental Income and Loss) from prior years - rental real estate losses are generally considered passive unless you're a real estate professional or materially participated under specific IRS tests. If you see entries on lines 23 and 24 of Schedule E that show passive losses being limited, those are the amounts that should have been tracked on Form 8582. The easiest way is to look at line 16 of your most recent Form 8582 before the sale year - this shows your total suspended passive activity losses carried forward. This number should roughly match your $130K figure (accounting for any intervening years' activity). If there are discrepancies, you might want to reconcile the numbers before filing this year's return.

Great point about Revenue Ruling 87-9 and the NIIT! I hadn't considered the Net Investment Income Tax aspect. Quick question - when calculating whether I hit those MAGI thresholds for NIIT, do I use my income BEFORE applying the suspended passive losses, or AFTER? In other words, if my regular income is $180K and I have a $15K net gain after applying passive losses, am I at $195K for NIIT purposes, or would it be higher before the passive loss offset is applied? This could make a big difference in whether I'm subject to that 3.8% tax.

For NIIT purposes, you use your MAGI AFTER applying the suspended passive losses. The passive losses reduce your overall income first, then you determine if you're above the NIIT thresholds. So in your example with $180K regular income + $15K net gain after passive losses = $195K MAGI, you'd be below the $200K single threshold and wouldn't owe NIIT. However, be careful about other components of MAGI that might push you over - things like investment income, capital gains from other sources, etc. The passive loss offset applies to reduce the gain from the rental property sale, but your total MAGI includes all income sources. Also worth noting that if you're married filing jointly, you have more room with the $250K threshold. The key is that suspended passive losses are a "below the line" adjustment that reduces your AGI, which then flows through to your MAGI calculation for NIIT purposes.

This is incredibly helpful! Thank you for providing all the specific citations - especially Revenue Ruling 87-9, which I hadn't come across in my research. Quick question about the Form 8582 filing: when I complete it for the year of sale, do I need to show the full $130K of suspended losses being released on one line, or does it get broken down by activity/property? I only have the one rental property, but I want to make sure I'm filling out the form correctly to avoid any red flags with the IRS.

Since you only have one rental property, you'll report the suspended loss release on a single line in Part II of Form 8582. You'll list your rental property as one passive activity, and when you dispose of your entire interest, all the accumulated suspended losses from that activity ($130K in your case) get released together. In Part II, you'll enter the name/description of your rental activity, check the box indicating "Disposition of entire interest," and enter the $130K in the appropriate column. The form will then calculate how much of those losses can be used to offset your current year income (which would be all of it since you're disposing of the entire interest). The key is making sure the $130K figure you enter matches what was carried forward from your previous year's Form 8582 line 16. If there's any discrepancy, you might want to prepare a reconciliation statement to include with your return showing how you arrived at that number.