Tax Deduction If Selling Rental Property at a Loss

Unloading your rental property for less than you purchased it for? The loss could be deductible against your ordinary income.

By , Attorney (Benjamin N. Cardozo School of Law)

You doubtless 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 is often unkind to property investments in certain parts of the United States. 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, you might be able to turn lemons into lemonade, in the form of tax benefits.

Ordinary Income Tax vs. Capital Gains Tax

In case you don't have much grounding in tax law, a few definitions will help navigate the implications of your rental property sale. 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 federal 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's page on Capital Gains and Losses.

Using Your Tax Basis to Calculate Your Loss

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 property's tax basis, add the amount you it 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 might be deductible.

No Deduction Allowed for Sale of Primary Residence

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.

Converting Personal Residence to Rental Property for Purposes of Deducting Losses

Don't expect to be able to sidestep 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.

Getting Professional Help Could Be Worth the Cost

As you can appreciate, the nuances of rental property sales can be complex. 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 expensive if done incorrectly. The upfront cost of a professional consultation is far less than the risk of an IRS audit of what will be a substantial sum of money.

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