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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 investment real estate at a loss, consider how it could affect your taxes. For instance, you might be wondering whether you can you write off losses on the 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 property can generate taxes while you own it and again when you sell it. Rental income is generally taxable, although owners may be able to deduct eligible expenses such as property taxes, insurance, repairs, management fees and depreciation. Depreciation allows you to deduct part of the property’s cost over time, but it also reduces your adjusted basis, which can increase the taxable gain when the property is eventually sold.
When you sell investment property for more than its adjusted basis, the difference is generally taxable. Property held for more than one year may qualify for long-term capital gains treatment, while gains on property held for one year or less can be taxed at short-term rates. For depreciable real estate, part of the gain attributable to prior depreciation may also be taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25%.
A sale at a loss can receive different tax treatment depending on how the property was used. If rental real estate was used in a trade or business, a deductible loss may be reported on Form 4797 and can potentially receive ordinary-loss treatment. If the property was held strictly as an investment rather than used in a trade or business, the loss is generally treated as a capital loss and reported on Form 8949.
The distinction matters because capital losses are subject to limits when they exceed capital gains, while qualifying ordinary losses can generally provide more immediate tax relief. Personal-use property follows different rules, and losses on property that was not held primarily for profit generally are not deductible.
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, you can deduct losses from your 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 must compare the property’s sale price 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 write off a loss from selling an investment property, you may be able to use it for tax-loss harvesting. The IRS allows investors to use capital losses to offset capital gains from the sale of stocks and other investments. If your capital losses exceed gains or you have none, you can deduct up to $3,000 of losses per year. You can, however, carry forward excess deduction amounts to future tax years.
Run your numbers to get a clearer picture of your overall tax liability before choosing a deduction approach.
Can You Write Off Losses on the 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 you’re selling an investment property for the first time, consider consulting a tax professional about claiming a loss deduction. 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, you cannot deduct a loss. 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 becomes its value at the time of the conversion, minus 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 create a tax deduction, but the size and type of that deduction depend on how the property was used and how the loss is classified. Rental or business property may qualify for ordinary-loss treatment in some cases, while investment property losses may be treated as capital losses and subject to annual deduction limits. Understanding your adjusted basis, depreciation history and the property’s tax classification can help you determine how much of the loss may actually reduce your tax bill.
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. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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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