It’s probably safe to say that most real estate investors don’t purchase rental property with the goal of selling at a loss. However, despite an investor’s best efforts, sometimes rental property is sold at a loss.
Although no investor likes the idea of losing money, there are potential advantages to selling a rental property at a loss. In this article, we’ll look at how rental property losses work, discuss how to calculate a loss on a rental, and explain why an investor may still need to pay tax even when a rental property is sold at a loss.
Key Takeaways
- Real estate investors are taxed on ordinary income and capital gains.
- A capital loss is generated when a rental property is sold for less than the cost basis.
- Capital loss from one asset can be used to offset capital gains from the sale of another asset, and used as a deduction from ordinary income, with any unused capital loss carried forward to future years.
- Tax on depreciation recapture can generate a tax liability for a real estate investor, even when a rental property is sold at a loss.
- A certified public accountant, enrolled agent, or other licensed tax professional can provide further guidance about potential tax liabilities related to the sale of rental property.
Income, Capital Gains, and Rental Property Losses
There are two main ways that real estate investors make (or lose) money from a rental property, and each is taxed differently:
Ordinary Income
Ordinary income is the net taxable income (or loss) generated after collecting tenant rents and deducting operating expenses and depreciation. At the federal level, most real estate investors use Schedule E (Form 1040) to report income and expenses received from a rental property each year to the IRS. Income from a rental property is taxed at an investor’s federal income tax bracket, which ranges from 10% to 37% for 2021.
Capital Gains
Long-term capital gains (or losses) are generated when a rental property is sold after being held for more than one year. Most real estate investors report capital gains on Schedule D (Form 1040). Income from capital gains is taxed differently than ordinary income. The current capital gains tax rates are 0%, 15%, or 20% depending on an investor’s level of annual income.
Short-term capital gains are generated when a property is sold after being held for one year or less, such as when investors fix and flip a home. Any short-term gain generated is treated as ordinary income and taxed based on the investor’s tax bracket.
Rental Property Losses
When a property is sold for a profit, those profits are reported and taxed as capital gains. However, if a rental property is sold at a loss, those losses are deductible from ordinary income, subject to certain limitations. IRS Topic No. 409 Capital Gains and Losses provides more information on short-term and long-term income and capital gains tax rates.
How to Calculate a Rental Property Loss
The process for calculating a rental property loss are relatively straightforward and can be done in just a couple of steps:
- Calculate the cost basis of the property, which is the original purchase price of the property plus any capital improvements made during the holding period, such as installing a new roof or HVAC (heating, ventilation, and air conditioning) system.
- Subtract the cost basis from the sales price of the property, less any tax deductible expenses like closing costs and sales commission. If the result is a negative number, the result is a long-term capital loss, provided that the rental property has been held for more than one year.
Example of Calculating a Rental Property Loss
Now let’s look at a simple example of how to calculate the loss on a rental property.
A little over one year ago, Ted and Alice purchased a fixer-upper rental home that needed a new roof and HVAC system. The purchase price of the house was $100,000 and the capital improvements totaled $20,000, making the property cost basis $120,000.
Originally, the couple planned on holding the home for several years with the goal of generating passive rental income and hopefully selling at a profit. Unfortunately, their plans changed, and now Ted and Alice are getting a divorce and need to sell the rental property fast.
Ted and Alice list the rental property for sale on the Roofstock Marketplace — the number one marketplace for buying and selling investment properties — and quickly receive an offer from another investor. After deducting the sales commission (which is only 3% of the $123,000 sales price on Roofstock) and other closing costs, the adjusted sales price comes in at $118,000.
By subtracting the cost basis of $120,000 from the adjusted sales price of $118,000, Ted and Alice have a loss on the rental property of $2,000 that can be deducted from the couple’s other taxable net income.
The above example is simplified and calculating an actual rental property loss can be much more complicated. Stessa, a free online and mobile application property management solutions provider, helps make rental property finances simple by automatically tracking income and expenses, recording them in the proper accounts, and updating the balance sheet to report the property cost basis in real-time.
How to Offset Capital Gains with a Loss
A capital loss from the sale of one asset can be used to offset the capital gains from another asset that is sold in the same tax year. This process is known as tax loss harvesting, and is used by some investors to help improve investing returns.
For example, if a rental property is sold for a loss of $2,000 and another rental home is sold for a gain of $2,000, the total amount of profit subject to capital gains tax would be $0. Or, an investor may sell stock for a loss of $3,000, then use that capital loss to offset the gain from a rental property sale.
Using a Loss Carryover
The IRS has placed a limit on capital loss deductions. If capital losses exceed capital gains, the amount of the excess loss is limited to $3,000 per year. Fortunately, any excess loss doesn’t go to waste. Investors can carry the loss forward to later years.
As an example, assume an investor sold a rental property at a loss of $10,000. If the investor has no other capital gains, $3,000 could be deducted from the investor’s ordinary income this year, with the unused capital loss of $7,000 carried forward to future years.
Impact of Depreciation Recapture
When a rental property is sold at a loss, a real estate investor may still owe tax on the property because of depreciation recapture.
The IRS allows a residential rental property to be depreciated over a period of 27.5 years. So, each year that the property is held, 3.636% of the cost basis can be deducted as a depreciation expense from the rental property’s pre-tax net income. That’s why depreciation is often considered one of the biggest benefits of investing in real estate.
But when the rental property is eventually sold, the IRS requires a real estate investor to “recapture” depreciation so that it can be taxed. Recaptured depreciation is treated as ordinary income and taxed at an investor’s normal tax bracket up to a maximum of 25%.
To illustrate how depreciation recapture works, let’s go back to Ted and Alice.
During the brief time the couple owned the rental property, they were able to claim a depreciation expense of $4,000 to reduce their taxable net income. When the property is sold, Ted and Alice will owe tax on recaptured depreciation of up $1,000 ($4,000 depreciation expense x 25% maximum depreciation recapture tax), depending on the tax bracket that the couple is in.
So, even though Ted and Alice had a capital gains loss of $2,000 when their rental property was sold at a loss, they will still owe up to $1,000 in tax due to capital gains recapture.
Reporting a Rental Property Loss to the IRS
There generally two forms a real estate investor uses to report a rental property loss to the IRS. Form 8949, Sales and Dispositions of Capital Assets is used to calculate a capital loss (or gain). Then, the capital loss reported on Form 8949 is transferred to line 7 of Form 1040 or 1040-SR.
As a reminder, the yearly limit on the amount of the capital loss that can be deducted is $3,000 (or $1,500 if a couple is married but files a separate return).
The following IRS links provide more information on how a real estate investor can report a rental property loss:
- IRS FAQ Sales, Trades, Exchanges 1
- Form 8949, Sales and Other Dispositions of Capital Assets
- Form 1040, U.S. Individual Income Tax Return
- Form 1040-SR, U.S Tax Return for Seniors
Potential Strategy: Converting Personal Residence to a Rental Property
The IRS only allows loss deductions for investment or rental property, not for a personal residence. Sometimes people consider converting their primary residence to a rental property, then selling it in order to generate a capital loss.
While converting an owner-occupied home to a rental property is possible, losses in value only apply from the time the property was converted into a rental going forward, according to the legal resource website Nolo.com.
For example, assume a homeowner purchased their primary residence for $250,000 and the property is now only worth $225,000. If the homeowner converts the property into a rental, the cost basis for capital gains purposes is $225,000. The property would need to lose value above and beyond $225,000 in order to generate a capital loss when the property is sold.
Wrapping Up
While selling a rental property at a loss isn’t an easy decision, sometimes real estate investors have no other choice. Death, divorce, or a change in investing strategy are three of the reasons why an investor may decide to sell a rental property at a loss. In addition, an investor may choose strategically to sell an underperforming property at a loss in order to offset capital gains earned on another investment.
As discussed above, tax law is relatively friendly to real estate investors even if there is a capital loss. The amount of loss can be used to offset other capital gains, a capital loss of up to $3,000 each year can be deducted from ordinary income, and any unused capital loss can be carried forward into future years.
