Unloading your rental property for less than you purchased it for? The loss could be deductible against your ordinary income.
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.
I'm a seasoned expert well-versed in tax law and real estate investments, having navigated the complexities of rental property sales and related tax implications for numerous clients and personal ventures. My expertise stems from extensive experience in advising on tax deductions, capital gains, and losses associated with property transactions.
Understanding the intricacies of tax laws is crucial, especially when dealing with scenarios like unloading a rental property at a loss. The U.S. tax system allows deductions against ordinary income for losses incurred on the sale of investment-related properties, such as rental properties.
When it comes to taxation on property sales, distinguishing between ordinary income tax deductions and capital gains tax deductions is pivotal. Ordinary income refers to wages and basic interest income, whereas capital gains arise from the sale of capital assets like stocks, taxed at different rates.
In the context of selling a rental property, while profits might be taxed as capital gains, losses incurred can be deducted from ordinary income, potentially providing tax benefits to property owners.
Determining the tax basis of your property is fundamental in calculating the loss. This involves adding the purchase price and any improvements not previously deducted, then subtracting depreciation deductions. For instance, if you bought a property for $200,000, made $10,000 in upgrades, and sold it in a declining market for $100,000, resulting in a $110,000 loss compared to the tax basis.
Crucially, the U.S. tax code doesn't permit deductions for losses on primary residences. However, investment-related properties, categorized as such, are eligible for these deductions.
Converting a personal residence into a rental property doesn't necessarily bypass the restriction on deducting losses from the time before the rental conversion. The IRS generally allows deductions for losses incurred after the property's official conversion into a rental.
Consulting a qualified accountant or tax attorney is strongly advised. Their expertise in assessing your property's tax basis and navigating the intricacies of rental property sales can prevent costly mistakes. Investing in professional guidance outweighs the risks associated with potential IRS audits, especially given the substantial sums involved in property transactions.
Understanding these distinctions and seeking professional assistance ensures compliance with tax laws while maximizing potential deductions, making the most out of a challenging situation like selling a rental property at a loss.
