Of course, you didn’t plan on losing money when you decided to sell your rental property. Unfortunately, the real estate market is always fluctuating and oftentimes properties can’t sell for the price they were paid for.
Determining if It Was a Loss
Before you do anything, you should determine whether or not you actually sold your rental property for a loss. To figure out if the sale caused a tax gain or loss, you will need to compare the property’s sale price to its tax basis. The tax basis is calculated by adding your original purchase price to the cost of improvements (not including repairs or general maintenance) and subtracting any depreciation deductions you claimed while you owned the property.
Depreciation tax deductions allow taxpayers to recover the cost or other bases of properties. Basically, it’s an annual allowance for the wear and tear, deterioration, or obsolescence of the property. You should try calculating your tax basis before you sell the property so that you’re sure about the status of the loss. Beware that if you decide to sell the property blindly, and then find out it was for a gain, you’ll end up having a higher tax bill.
If It Really Was a Loss…
If you calculate your tax basis and find out you are really at a loss, there actually may be some good news. Let’s say you sold a rental property that you owned for over a year — that loss will be considered a Section 1231 loss. Section 1231 losses can be used to reduce any type of income you may have, including salary, bonuses, self-employment income, capital gains, and so on. If the loss is large enough to reduce your other income below zero, you may also have a net operating loss (NOL). A NOL is an amount by which a taxpayer’s deductions exceed their gross income. This allows you to “carry back” the NOL for at previous years and use it to redeem taxable income. You can recover some or even all of the taxes you paid in previous years by amending those returns. In addition, you can “carry forward” the loss to a future year of profit and redeem it then.
Passive Activity Losses
You might have some passive activity losses (PALs) if your rental property generated losses in the past years. In general, you should be able to deduct these passive losses against passive income from passive rental/business activities. Generally, a passive activity is any rental/business activity in which the taxpayer does not materially participate. Nonpassive activities would be when the taxpayer works on a regular, continuous, and substantial basis.
You can also deduct suspended PALs when you sell your rental property. If you do this, you may be able to deduct these losses on top of any from Section 1231. Like Section 1231 losses, deductible PALs can offset income. You can offset capital gains by taking the tax-free profits of your sale’s loss, which is the difference between the property’s purchase and sale prices. The loss will simply cancel out the gain.
Even if you sold your rental property for a loss, you still didn’t really lose money. Fortunately, the IRS recaptures depreciation at a 25 percent tax rate. So, if you sold your property for $500,000 and bought it for $600,000, but depreciated it for $150,000, you’ll actually have a gain of $50,000 relative to the depreciated value of $450,000. Just make sure you work with a certified accountant so that you are aware of all aspects of your finances. At the end of the day, don’t look at your loss as a loss — it can actually be a gain.