Key Takeaways
- You can figure out if you've got a tax loss by comparing the sale price to your property's tax basis, which includes the original purchase price, improvements, and depreciation deductions.
- If you acquired the property through a Section 1031 like-kind exchange, your tax basis might be lower than expected, which could lead to a gain instead of a loss.
- If your rental property was held for more than a year and you sell it at a loss, it can typically qualify as a Section 1231 loss. This can offset various types of income, like salary and capital gains.
- A significant Section 1231 loss might result in a net operating loss, which you can carry back to offset past taxable income or carry forward to offset future income.
First make sure you actually have a tax loss
You might be looking at loss if you have to sell a rental home in a down market or have just had to put more money into a property than it is worth. To determine if you have a tax gain or loss, you will need to compare the property’s sale price to its tax basis. The tax basis is generally your original purchase price, plus the cost of improvements (not counting expenses you’ve deducted as repairs and maintenance), minus any depreciation deductions you claimed while you owned it.
Be careful if you acquired the property in a tax-deferred Section 1031 like-kind exchange—where you swapped another property for the one you’re thinking about selling. With a 1031 exchange, you defer paying the tax on a gain from selling one property by exchanging it for another property. To avoid recognizing the gain on the sale of your first property, you can transfer your cost basis to the new property. This can result in a small amount of tax basis in the property that you are trying to sell. The property’s basis may be lower than you think.
Bottom Line: Make sure you know your property’s tax basis before you sell. That way you won’t be expecting a loss and instead wind up with a gain that increases your tax bill.
TurboTax can help you track your tax basis for your properties.
If you do have a tax loss, more favorable rules may apply
Let’s assume you do expect a tax loss from selling a rental property you’ve owned for more than a year. That loss will be a Section 1231 loss—which can be a good kind of loss to have. Here’s why.
First, Section 1231 losses can be used to reduce any type of income you may have—salary, bonus, self-employment income, capital gains, you name it.
Second, you may have a net operating loss (NOL) if the Section 1231 loss is large enough to reduce your other income below zero. If so, you can carry back the NOL for at least two years and use it to offset taxable income in those years. In doing so, you can recover some or all of the taxes you paid in those previous years by amending those returns.
If any of the NOL is left over after going back two years, you can carry the rest forward into future tax years to offset future income (for up to 20 years). Alternatively, you can choose to not to carry it back and just carry it forward for 20 years.
TurboTax Tip:
If your rental property generated passive activity losses in the past, you can deduct these when you sell the property, potentially increasing your overall deductible loss.
Deducting passive activity losses
If your rental property has generated losses in past years, you might have suspended passive activity losses (PALs). You can generally deduct these passive losses only against passive income, which can be from other activities such as rentals or other passive business activities.
Fortunately, you can also deduct suspended PALs when you sell the property that generated them. If you sell a rental property with suspended PALs, you may be able to deduct them on top of deducting any Section 1231 loss from the sale. Like Section 1231 losses, deductible PALs can offset other income and also create or increase an NOL that you can carry backward or forward.
Converting a personal residence into rental property
Losses from selling a personal residence are not deductible. Generally, you can only claim tax losses for sales of property used for business or investment purposes.
However, if you convert a personal residence into a rental property and then sell it for less than the original cost, will you then have a deductible loss? Maybe. The tax basis of the rental property is the lesser of the cost or the value when it is placed in service, plus any improvements, less any depreciation taken. So, if the house declined in value before converting it into a rental property you might have a low basis and not have a tax loss. However, a loss from a decline in value after conversion to a rental, is generally a deductible loss.
As an example, you convert your residence into a rental when the property’s cost basis is $350,000, and its FMV is $250,000. Later, you sell it for $210,000 after claiming $15,000 in depreciation write-offs. For tax loss purposes, your tax basis is $235,000 ($250,000 FMV on conversion date minus $15,000 depreciation = $235,000).
That means you do have a deductible loss, but it’s limited to $25,000 ($210,000 sale price - $235,000 basis = $25,000 loss). The rest of the loss starting from the original $350,000 purchase price is not a deductible loss.
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