Suspend PAL and cap gains

[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?

[Ashish Acharya]

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).