If I convert rental property to personal use, how can I use the suspended losses in future years?

Question

I have rented a townhouse for 22 years. Now my wife and I are thinking of moving into it, converting it to our personal residence. I have significant suspended deductions, primarily expenses, interest and depreciation, that I could not take due to our income level. If I convert the property to personal use, how can I use the suspended losses in future years?

Answer 1

I assume you actively participate. Your suspended losses are carried forward. They can be offset by passive income, or if your income allows some or all of the $25K special deduction, or until you sell your property as a business property, not your personal residence, to an unrelated party.

If you sold it as a business property, then any unused suspended losses would be subtracted from the capital gain (or result in a capital loss). However, you would not be able to subtract suspended losses from the capital gain on the sale of a personal residence, once you have converted it to your personal residence.

After you have lived in the house for two years, when you sell it, only the depreciation that was taken after May 6, 1997 will be recaptured as ordinary income, and only the amounts that were actually allowed given your passive loss limitations.

Depreciation that was allowed prior to May 6, 1997 will not be recaptured as ordinary income, but is part of the $500K maximum allowable exclusion.

Answer 2

Are you talking about losses limited by the passive activity loss limitation rules? Passive activity losses can only be used to offset passive income unless you actively participated in the rental activity. If you did, you can use up to $25,000 per year against non-passive income. Even so, the allowable loss is limited by your AGI. The limitation starts to kick in at AGI of $100k and the allowable loss is $0 at AGI of $150k.

Unallowed losses can be carried forward but you must keep track of which ones were covered by the active participation rules and which ones weren't. Losses not covered by the active participation rules can only be used against passive activities in future years. Losses covered by the active participation rules can be used against non-passive income in future years, assuming of course that you don't still run into the AGI limitations discussed above.

Any losses that you can't use in the future can be used to reduce the gain (or generate a capital loss) when you dispose of the property in a fully taxable sale to a non-related party.

"ninasgramma" below makes a good point about the non-use of the deferred losses on the sale of a personal residence and the treatment of depreciation.