I had someone approach me with a condominium sale in Chicago. The situation is confusing for many taxpayers as the property was cash-flow positive while being negative for schedule e tax reporting purposes. There were both accumulated disallowed passive losses as well as accumulated depreciation that possibly needed to be recaptured. Below are the facts of the case (numbers changed):
Individual purchases rental property:
Depreciation 25k per year for 7 years: $175
Total yearly 33k passive loss (including depreciation) per year for 7
Sale of home:
Sales proceeds: 720
Mortgage repaid: 350
What is the realized gain/loss? Math:
Long-term capital gain would be 215k calculated as follows:
Original Cost of $680 less accumulated depreciation of $175 = $505. This $505 is the adjusted basis of the property.
Then, the sale price is $720, leaving you with $215 in Long Term Capital Gains.
Assuming it was the only gain for the year, 175k of that gain would be taxed at a maximum 25% rate, as that was the amount of depreciation that now needs to be recaptured.
What about the passive activity losses? These would finally be “unlocked” by the sale of the condo and would be allowed in the year the condo is entirely disposed of. Although these losses do not reduce long-term capital gain, they can be used that year as ordinary losses to offset ordinary earned income from the individual’s W2.
What if the individual did not earn enough money and the amount of ordinary loss exceeds her/his income? Then these are Net Operating Losses that are carried forward indefinitely.