Specific Comments on the Proposed Section 121 Regulations
(Reg-105235-99; October 10, 2000)
May 1, 2001

IV.  Interaction of Sections 121 and 469

Background
Section 469 was added to the Internal Revenue Code by the Tax Reform Act of 1986 to require certain taxpayers (including individuals) to use losses from passive activities only against income from passive activities. A passive activity includes a rental activity. Regulations issued under Section 469 provide guidance to determine how much of a gain from the sale of property used or previously used in a passive activity is considered passive activity gross income to which passive activity losses (including losses carried forward from prior years) may be used. Section 469(g) provides that if an interest in a passive activity (or former passive activity) is disposed of in a fully taxable transaction, the passive activity loss is “triggered” to be used against any type of income in the year of disposition. However, if the disposition is one where realized gain is not recognized (such as a sale to which the gain exclusion of Section 121 applies), the passive activity loss is not triggered, but remains to be used against future passive activity income.

Reg. §1.469-2T(c)(2) provides that, generally, gain from disposition of property used in a passive activity is treated as passive activity gross income if the property was used in a passive activity in the year the gain is recognized. If the property is not used in a passive activity in the tax year of disposition, the gain is treated as not from a passive activity. Reg. §1.469-2T(c)(2)(ii) provides a “12-month lookback rule” to determine how much of the gain from the sale of property used in a passive activity some time in the prior 12 months is passive activity gross income. Under this rule, the amount realized and the adjusted basis “must be allocated among such activities on a basis that reasonably reflects the use of such interest in property during such 12-month period.”

Section 121(d)(6) provides that gain attributable to depreciation claimed on a residence after May 6, 1997 may not be excluded under Section 121.

Example: Mary rents her home out for one year, then lives in it for two years and finally rents it for two months before selling it at a gain of $100,000. Mary claimed $9,000 of depreciation on the home after May 6, 1997. Mary satisfies the ownership and use requirements of Section 121 and so, may exclude $91,000 of her realized gain ($9,000 must be recognized under Section 121(d)(6)).

While Mary’s home was rental property, it generated a passive activity loss (PAL) of $30,000, which remains at the disposition date. Under the 12-month lookback rule of Reg. §1.469-2T(c)(2)(ii), 2/12 of Mary’s recognized gain (from the depreciation recapture) would be passive activity gross income. Under Section 469(g), Mary’s PAL is not triggered. Under Reg. §1.469-2T(c)(2)(ii), only 2/12 of Mary’s gain is passive activity gross income ($1,500) so only $1,500 of her suspended $30,000 PAL is usable in the year of disposition of the property. If there had instead been no rental in the 12 months preceding the disposition, none of the recognized depreciation recapture gain would be passive activity gross income and the entire $30,000 PAL would remain. If Mary has no passive activities to generate passive activity gross income, the PAL will remain.

Comments
The Section 469 regulations characterizing gain from sale of property used (or formerly used) in a passive activity were written prior to the revision to Section 121 in 1997. New rules are needed to better coordinate the interplay of Sections 469 and 121.

Recommendation: The Section 469 regulations should be amended to provide that recognized gain from depreciation recapture under Section 121(d)(6) is treated entirely as passive activity gross income regardless of the use of the residence in the year of sale, provided the depreciation was a passive activity deduction.