Surely you didn't buy your second property with the hope or expectation that it would decline in value. Real estate markets fluctuate, however, and the U.S. economy has not been kind to property investments in many parts of the country. After years of renting our your second property, perhaps you're coming to realize that its value is significantly less than the purchase price. The good news is that you might be able to turn lemons into lemonade in the form of tax benefits.
In case you don't have much grounding in tax law, a few definitions will help you navigate the implications of your rental property sale. First, there are two broad categories of deductions to keep in mind: ordinary income tax deductions and capital gains tax deductions.
Ordinary income is, generally speaking, your wages and basic interest income – the main items that most taxpayers need to report on their IRS 1040 every April. Capital gains result from selling a capital asset, such as a stock, for more than its purchase price, or basis. Capital gains are taxed at lower rates than ordinary income, and are reported on Schedule D of the 1040.
Although profit on selling a rental property might have to be reported as capital gains, losses when selling rental property are deductible from your ordinary income. Learn more about the different types of taxable income on the Internal Revenue Service (IRS) website on “Capital Gains and Losses.”
The first step in calculating your loss is figuring out your property's “tax basis,” which you will later compare to your property's sale price.
To determine your tax basis, add the amount you purchased your property for, plus any improvements (for example, renovations or additions, but not repairs) that you haven't previously deducted from your taxes. These deductions include closing costs, such as legal fees and title insurance. Next, subtract any depreciation deductions that you've previously taken.
As an example, let's say you bought a property for $200,000 and made $10,000 in upgrades. This gives you a $210,000 tax basis. But you're in a rough real estate market, and need to sell for $100,000 – a huge loss. In fact, when you subtract your tax basis from your sales price, you find that your loss totals $110,000, for tax purposes. That loss may be deductible.
Importantly, the U.S. tax code does not allow deductions of losses for your residence, that is, the home you actually lived in – only for sale of investment-related property. As long as you've categorized your rental property as such, you should be able to take advantage of this benefit.
Although you may think that you can get around the personal-residence rule (described above) by simply converting your home into a rental property before selling, this only works to a point. The U.S. government will not allow you to deduct losses in value from the time period before the rental conversion.
In other words, if you lived on the property before you officially began reporting it to the IRS as a “rental property,” and the house declined in value before the conversion, this might not be considered a tax loss. However, a loss from a decline in value after conversion to a rental is likely deductible.
As you can appreciate, the nuances of these sales can be complex. Some are outlined on the IRS website on“Business or Rental Use of Home.” Make sure to consult an accountant or tax attorney and to figure out the tax basis of your property before you sell. This is a situation where “do it yourself” can be mostly if done incorrectly. The upfront cost of a professional consultation is far less than the risk of an audit of what will be a substantial sum of money.