10.16 Sales of Property and of Passive Activity Interests

Gain on the sale or disposition of property is generally passive or nonpassive, depending on whether your activity is passive or nonpassive in the year of sale or disposition. Thus, gain on the sale of property used in a rental activity is generally treated as passive income, as is the gain on property used in a nonrental business if you did not materially participate in the business in the year of sale. On the other hand, gain on the sale of property is generally nonpassive if the property was used in a business that you materially participated in during the year of sale. However, exceptions described below may change this treatment.

Where you transact an installment sale, treatment of gain in later years depends on your status in the year of sale. For example, if you were considered a material participant in a business, all gain is treated as nonpassive income, including gain for later installments. If you were in a rental activity or were not a material participant in a nonrental business, the gain is treated as passive income, unless the exceptions in this section apply.

Gain on substantially appreciated property formerly used in nonpassive activity.

Even if an activity is passive in the year that you sell substantially appreciated property, gain on the sale is treated as nonpassive unless the property was used in a passive activity for either 20% of its holding period or the entire 24-month period ending on the date of the disposition. Property is substantially appreciated if fair market value exceeds 120% of its adjusted basis.

Property used in more than one activity in a 12-month period preceding disposition.

You are required to allocate the amount realized on the disposition and the adjusted basis of the property among the activities in which the property was used during a 12-month period preceding the disposition. For purposes of this rule, the term “activity” includes personal use and holding for investment. The allocation may be based on the period for which the property is used in each activity during the 12-month period. However, if during the 12-month period the value of the property does not exceed the lesser of $10,000 or 10% of the value of all property used in the activity at the time of disposition, gain may be allocated to the predominant use.

Disposition of partnership and S corporation interests.

Gain or loss from the disposition of an interest in a partnership and S corporation is generally allocated among the entity’s activities in proportion to the amount that the entity would have allocated to the partner or shareholder for each of its activities if the entity had sold its interest in the activities on the “applicable valuation date” chosen by the entity, either the date of the disposition or the beginning of the entity’s taxable year in which the disposition occurs.

Gain is allocated only to appreciated activities. Loss is allocated only to depreciated activities. The entity may select either the beginning of its tax year in which the holder’s disposition occurs or the date of the disposition as the applicable valuation date.

Claiming suspended loss on disposition of interest in passive activity.

A fully taxable sale of your entire interest or of substantially all of your interest to a nonrelated person will allow you to claim suspended loss deductions from the activity (10.13).

Dealer’s sale of property similar to property sold in the ordinary course of business.

IRS regulations set down complex tests that determine whether the result of the sale is treated as passive or nonpassive income or loss.