Selling an investment property at a loss may not be ideal but it may be necessary if you need cash or you simply no longer wish to own the property. Before selling rental properties or other investment real estate at a loss, it’s important to consider the tax implications. For instance, you might be wondering when can you write off loss on sale of investment property. The short answer is yes, if you understand how deducting capital losses works.
A financial advisor could help you create a financial plan for your investment property needs and goals.
How Investment Property Is Taxed
Investment properties can generate two types of tax liability:
- Ordinary income tax
- Capital gains tax
Ordinary income tax on an investment property is the net taxable income that’s left after you deduct operating expenses and depreciation from rent payments received. Your investment property income is taxed at your regular income tax rate.
Capital gains tax applies when you sell an investment property for more than what you paid for it. The short-term capital gains tax rate applies to investment properties held for less than one year. You might pay this tax if you’re flipping houses, for example. Long-term capital gains tax applies to investment properties held for longer than one year.
Understanding these types of income tax matters for determining what you can deduct when selling investment property at a loss.
Can You Write Off Loss on Sale of Investment Property?
Selling an investment property at a loss means accepting less than what you initially paid for it. Generally, when a rental or investment property is sold at a loss your losses can be deducted from ordinary income. Again, this is the income most people report on a Form 1040 each year when they file their taxes.
In order to write off a loss from the sale of investment property you first have to determine that a loss exists. To do that, you’ll need to compare the sale price of the property to its tax basis. If you’re unfamiliar with tax basis it’s the adjusted cost basis of an asset. Here’s what the formula for determining tax basis looks like:
Original Purchase Price + Cost of Improvements – Depreciation Deductions
Here’s an example of what this might look like when selling investment property at a loss. Say you purchased an investment property for $500,000. You invested $100,000 in repairs and renovations, bringing your total investment to $600,000. You then sell the property in a down market for $450,000, resulting in a $150,000 capital loss.
Assuming the property was held longer than one year before the sale, this would be a long-term capital loss. That can be useful later for tax-loss harvesting, which involves using capital losses to offset capital gains.
How to Report Rental Property Losses on Your Taxes
When you sell an investment property at a loss, you’ll need to report it on Schedule D of your Form 1040 to claim a deduction. Remember that deductions reduce your taxable income which could mean paying less in taxes or getting back a larger refund.
To get the numbers you need to enter on Schedule D, you’ll first need to complete IRS Form 8949, Sales and Dispositions of Capital Assets. This form is used to calculate your capital loss (or capital gain if you’re selling investments for a profit). This is carried over to your Form 1040.
If you can write off a loss from the sale of an investment property, consider how you can use that for tax-loss harvesting purposes. The IRS allows investors to use capital losses to offset capital gains from the sale of stocks and other investments. If you have no capital gains or your capital losses exceed capital gains, any excess loss deduction is capped at $3,000 per year in capital loss deductions. You can, however, carry forward excess deduction amounts to future tax years.
Can You Write Off Loss on Sale of Investment Property and Still Owe Taxes?
Deducting losses associated with the sale of an investment property does not guarantee that you won’t still owe taxes to the IRS. You also have to factor in depreciation recapture and how that might affect your tax liability.
The IRS looks at the total amount of depreciation deductions claimed against the property. If you sell an investment property for more than your depreciated basis then a 25% depreciation recapture tax is assessed. So if your depreciated basis in a property is $400,000, for example, and you sell it for $450,000 then you’d owe 25% of that $50,000 difference or $12,500 in taxes.
If it’s your first time selling an investment property, you may want to consider talking to a tax professional about how to claim deductions for loss. You could also talk to your financial advisor about how to make your investment portfolio more tax-efficient overall.
Converting Personal Residence to Rental Property: Can You Deduct Losses?
Loss deductions are only allowed for the sale of investment properties. If you’re selling a home that you’ve used as a primary residence, the loss is not deductible. There is, however, a potential loophole to this rule.
You could convert your primary residence to a rental property in order to deduct a loss when you sell it. There is a catch to this. Any losses in value that occurred before the rental conversion would not be deductible. So if the home’s value when down while you were still living in it, that would not be deductible. You may, however, be able to write off declines in value that happen after the property is converted.
Here’s an example of how that works. Say that you convert your principal residence to a rental property. At the time of the conversion, your cost basis in the property is $400,000 and the property’s fair market value is $300,000. You rent out the property for another six months, during which time its value drops to $200,000. Your tax basis in the property would be its value at the time of the conversion, less any depreciation. You’d only be able to deduct the difference between the $300,000 it was valued at and the $200,000 you sold it for, minus any depreciation deductions you claimed during that time.
Bottom Line
Selling an investment property at a loss can mean taking a financial hit but it may be unavoidable if you’re forced to sell during a period of market decline. Understanding when you can write off a loss from the sale of an investment property could help you to enjoy some tax benefits.
Tips for Real Estate Investing
- Consider talking to a financial advisor about when it may be the right time to sell an investment property, especially if it means selling at a loss. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Be aware that special tax rules may apply if the investment property you’re selling at a loss was originally acquired as part of a 1031 exchange. This type of transaction is often used to defer capital gains tax on the sale of investment property by exchanging it for a similar property. In order to avoid having to pay tax on the capital gains from the sale of the property, you’d have to transfer your cost basis to the new property.
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