Selling rental and investment property at a loss comes with financial and tax implications, or even opportunities, but it is certainly not ideal. Either you need more cash on hand for business or personal expenses, or the cost of owning and maintaining the property is so unprofitable that an immediate sale is necessary.
Today, I want to touch on a few different strategies we can use to deduct property losses from what you pay in taxes. Success is dependent on planning, analysis, and timing.
Can I deduct losses from the sale of investment property?
The short answer to the big question is yes, and you can sell investment property at a loss and deduct the losses, or a portion of the losses, from your taxable income. Turning losses into tax savings is going to require tax planning, so before you execute any of the strategies or calculations in today’s article, be sure to get in contact with my team or another proactive firm.
So, let’s take a look the questions that we need to answer if we want to successfully implement a tax-saving strategy.
- Can I use capital losses to offset capital gains taxes?
- When should I consider utilizing capital loss carryover?
- How do I apply losses against taxable ordinary income?
- Does my income affect my ability to offset rental property losses?
- Why is calculating cost basis and tax basis critical to all strategies?
- Which strategies should I avoid?
From now on, I will use the terms “investment property” and “rental property” interchangeably. Also, this article is focused on selling at a loss, so if you’re interested in alternate strategies to avoid capital gains tax, see my article on 1031 exchanges.
Let’s get started.
Offset capital gains taxes with rental property losses.
When an investment property is sold at a loss, the loss is classified as a capital loss rather than an ordinary loss because investment property is a capital asset. On the other hand, when you sell an investment property for more than what you paid for it, the proceeds are classified as a capital gain and are subject to capital gains tax.¹
To sum up, capital gains taxation results from selling a capital asset, such as a stock, for more than its purchase price or basis.¹ Capital losses can offset capital gains, reducing overall tax liability.²
High-income owners should focus on a strategy to offset capital gains.
Let’s say you’ve sold other assets, such as stocks or additional real estate, for a profit in the same tax year; you can use your capital loss from the rental property sale to offset those gains. This strategy can be particularly advantageous for high-income individuals who are subject to higher capital gains tax rates.²
Be strategic when using property sale losses to offset capital gains.
Timing matters. We assess the current and projected state of our clients’ financial assets—property, stocks or bonds, or other types of investments—before opting for a capital gains offset strategy.
With a balanced portfolio, you can offset losses with a range of assets that are not core portfolio pieces.
For example, suppose you have a portfolio with investments that have appreciated. In that case, there’s an option to keep them in the market or sell the assets the same year you anticipate taking a loss on the sale of a property. Now, we have to balance the severity of the loss against the potential future growth of your investments.
Because our team partners with wealth management firms, we can select specific investments that you can sell for a profit now, but that may not be critical to your portfolio’s performance. You should also consider transaction costs and other costs associated with portfolio management.
Capital losses are directly deductible against capital gains dollar-for-dollar in a business’s gross taxable income—until capital losses fall short of or exceed the capital gains.
Use the IRS’s capital carryover loss provision if losses exceed gains.
If your capital losses surpass your capital gains within the year, the IRS permits you to carry over the unused amount to subsequent years. This provision spreads the loss over to the next tax year. You can continue to carry over these losses indefinitely. So, essentially, we’re continuing to reduce your tax burden until the loss is fully absorbed.
Is your property a short and long-term asset? It matters for capital loss carryover.
A rental property owned for less than one year is considered a short-term asset, while a property owned for a year or more is regarded as a long-term asset or section 1231 property.⁴,⁵ Accordingly, rules for short and long-term losses and gains apply.
“When you carry over a loss, it remains long-term or short-term. A long-term capital loss you carry over to the next tax year will reduce that year’s long-term capital gains before it reduces that year’s short-term capital gains.”²
So, you should consult a team of tax professionals to learn more about how this may affect your strategy.
Excess losses can be applied to offset regular income.
Property owners can also use capital losses to offset taxable regular income—a deduction of up to $3,000 annually for married couples filing jointly or $1,500 for single filers.⁵
Similar to the carryover loss provision, a business owner or individual who qualifies for a $3,000 deduction is not in an ideal position. His capital losses have exceeded capital gains.
However, suppose that the $3,000 deduction means that he’s neutralized capital gains tax liability with capital losses, and his capital losses only surpassed capital gains by between zero and $3,000. In that case, that’s fantastic tax planning, advisory, accounting, and wealth management at work.\
The downsides for high-income individuals and regular income deductions.
Rental properties are subject to IRS passive activity loss rules, and rental income or loss is generally classified as passive, which means certain limitations apply when deducting capital and regular losses. However, a specific rule empowers qualifying individuals and estates to offset up to $25,000 of nonpassive income using rental real estate losses and credits.⁶
If your adjusted gross income (AGI) is below $100,000, you may be able to deduct up to $25,000 in rental property losses against your regular income. However, as income increases, the allowable deduction phases out. For those with higher incomes, the ability to use passive losses may be limited.
To qualify for this $25,000 deduction, the taxpayer must consistently own at least 10% of the total value of all interests in the rental activity throughout the tax year. Furthermore, it is essential that the taxpayer actively participates in the management of the rental property during both the year the loss is incurred and the year in which the deduction is claimed.⁷
We have to know the exact amount of capital loss before we decide on a strategy.
Before we can execute capital gains offsets, capital loss carryover, or ordinary income tax-reduction strategies, we have to calculate the extent of your losses. This means knowing the cost basis and tax basis of your property. It’s the first step because to file for capital loss deductions, you need to confirm that a loss has occurred.
Let’s start with the adjusted cost basis, i.e., tax basis.
We must know a property’s adjusted cost basis before we identify capital losses. Determining the cost basis of a rental property can be complex, and its accuracy depends on the accuracy of the accounting processes and documentation.
How about a full list to demonstrate?
Here are some expenses and costs that increase your property’s cost basis.
Capital improvements increase the cost basis because they make the property worth more than what was paid for it initially. Improvements involve construction, design, legal, and administrative costs. Some are directly related to additions, replacements, and renovations, and some are incidental:
- Cost of labor and materials
- Charges for installing utility services and conducting property surveys
- Fees for legal, design (architect’s fees), inspection, appraisal, and titles
- Building permit charges
- Payments to contractors and for rental equipment
- Real estate transfer taxes
- Zoning costs
- Owner’s title insurance
- Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.⁸
It’s critical to track property improvements and other expenses because the combined savings-potential significantly tilts the tax implications of selling property at a loss in your favor.
Here are some existing deductions and items that decrease your property’s cost basis.
Many tax-saving deductions, credits, and exclusions decrease the cost basis of your property. Why? Because the cost basis is used for tax purposes, and you’ve already deducted (or had the chance to deduct) the following items:
- Section 179 deductions
- Exclusion from income of subsidies for energy conservation measures
- Casualty or theft loss deductions and insurance reimbursements
- Depreciation applied to the property.⁸
Okay, we’re dealing with a lot here. That’s why I recommend year-round tax planning and working with wealth management partners and legal partners.
Let’s break down cost basis and property loss into two simple equations.
Here’s the simple version of how to use the adjusted costs basis or tax basis of your property to calculate the capital loss at the time of sale.
Equation #1: Simplifying the formula for adjusted cost basis.
- (Purchase Price + Cost of Improvements) – (Depreciation & Deductions) = Adjusted Cost Basis/Tax Basis
Equation #2: Using adjusted cost basis to calculate capital loss
- (Adjusted Cost Basis) – (Sale Price) = Capital Loss
Let’s take a look at some strategies that are not going to pass muster with the IRS.
Property sale losses are reserved for commercial or residential properties related to investment.
Deductions for losses are only permitted for investment-related properties. If you have classified your rental property appropriately, you can take advantage of this tax benefit, minimizing the negative tax implications of selling property at a loss.
Be sure to check the status of a second home used for rentals or other residential properties and ensure that they are classified correctly. In other words, “I do not live here. This property generates income and is a capital asset.”
Do not attempt to convert a personal residence to a rental property.
Don’t assume that you can bypass the personal residence rule by simply converting your home into a rental property before selling it. This strategy has its limitations. For example, you will not be able to deduct any losses in value that occurred during the time you lived in the property before officially reporting it to the IRS as a rental.⁹
So, if you lived in the property prior to its classification as a rental and the home’s value decreased during that period, you will not be able to claim that as a deductible loss. However, any loss in value that occurs after you convert the property to a rental is likely deductible.¹⁰
So far, I haven’t mentioned it. If you’re a regular reader or fellow financial professional, you may be asking, “When is he going to make the connection?” Yes, this is tax-loss harvesting for rental and investment properties. The tax implications of selling investment property at a loss are similar to the impact of selling stock at a loss.
Take a loss, take a gain, get a plan.
If you enjoyed this article or made it this far, then I think we need to talk and get acquainted with my team. There’s no time for bean counting and tax preparation. Small business owners need help dealing with the tax implications of selling property at a loss or gain. The goal is to significantly reduce the cost of doing business.
Schedule a discovery call if you’re not happy with the results you’re seeing now.
Talk soon,
Jeremy A. Johnson, CPA
References
- IRS. Publication 550, Investment Income and Expenses (Including Capital Gains and Losses) [Internet]. IRS.gov. Internal Revenue Service; 2024 Apr. Available from: https://www.irs.gov/pub/irs-pdf/p550.pdf
- IRS. Topic No. 409 Capital Gains and Losses | Internal Revenue Service [Internet]. IRS.gov. 2024 [cited 2024 Dec 18]. Available from: https://www.irs.gov/taxtopics/tc409\
- IRS. Publication 544 (2019), Sales and Other Dispositions of Assets | Internal Revenue Service [Internet]. IRS.gov. 2024 [cited 2024 Dec 26]. Available from: https://www.irs.gov/publications/p544
- IRS. Residential Rental Property – Publication 527 [Internet]. Vol. 9, IRS.gov. 2024 [cited 2024 Dec 15]. Available from: https://www.irs.gov/pub/irs-pdf/p527.pdf
- IRS. Instructions for Form 8949 (2019) | Internal Revenue Service [Internet]. IRS.gov. 2024. Available from: https://www.irs.gov/instructions/i8949
- IRS. Sales of Business Property (Also Involuntary Conversions and Recapture Amounts under Sections 179 and 280F(b)(2)) [Internet]. IRS.gov. 2024 Dec [cited 2024 Dec 7]. Available from: https://www.irs.gov/pub/irs-prior/f4797–2024.pdf
- IRS. Passive Activity and At-Risk Rules, Publication 925 [Internet]. IRS.gov. 2024 Mar [cited 2024 Dec 11]. Available from: https://www.irs.gov/pub/irs-pdf/p925.pdf
- Cornell Law Schol. 26 U.S. Code § 469 – Passive Activity Losses and Credits Limited [Internet]. LII / Legal Information Institute. 2021 [cited 2024 Dec 15]. Available from: https://www.law.cornell.edu/uscode/text/26/469
- IRS. About Publication 551, Basis of Assets | Internal Revenue Service [Internet]. www.irs.gov. 2023 [cited 2024 Dec 22]. Available from: https://www.irs.gov/forms-pubs/about-publication-551
- IRS. Instructions for Form 4797 [Internet]. IRS.gov. 2024 Jan [cited 2024 Dec 16]. Available from: https://www.irs.gov/pub/irs-prior/i4797–2023.pdf