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Loss on Sale of Rental Property: Deductible Tax Write Offs & More

Selling your investment property and facing a loss can be tough. It doesn’t just dent your financial plans; it also makes you worry about the taxes you might owe.

The thing is, this loss on sale of rental property not only affects your investment goals but also adds the complexity of dealing with tax write-off. Figuring out how to handle these challenges becomes really important.

But all is not lost! We’re about to delve into the intricacies of the loss on sale of rental property, exploring deductible tax write-offs, and more. By the end, you’ll have the knowledge and strategies to confidently address these issues and optimize your investment decisions. 

Disclaimer: The information provided in this article is for educational purposes only and should not be construed as legal advice. We are not experts in legal matters, and readers are encouraged to seek the proper professional legal counsel for specific guidance.

Concerned about selling rental property at a loss?

It’s all well and good knowing the answer to the question of, “should I sell my rental property?” However,  the sale of a rental property at a loss is a completely different ball game.

While reaching out to real estate agents, lawyers, and accountants can provide personalized advice tailored to your unique circumstances, check out our complete guide below — you may just find a golden nugget of information that you’ve been needing…

When to sell a rental property at a loss

Selling a rental property at a loss can be a strategic move in real estate investment. One common situation is when the rental property consistently generates negative cash flow, meaning the rental income doesn’t cover the mortgage, expenses, and maintenance costs.

Changes in the local real estate market, economic conditions, or personal circumstances can also influence this decision.

No matter your situation, it’s essential to weigh these factors against the potential tax benefits and long-term investment goals to determine the optimal time to sell your rental property at a loss.

Loss on sale of rental property: 7 common reasons

Selling a rental property at a loss can be a challenging decision, and understanding these common reasons behind it is crucial for informed real estate investment strategies:

  1. Dropping rent prices: When rent drops below what’s needed to cover mortgage payments and expenses, selling at a loss is an instant way to stop your bank account and income from bleeding.
  2. Boom of new construction: As more properties become available, the supply often outpaces demand. This increased competition can force property owners to lower their rental rates to attract tenants.
  3. Low cap rate: A low capitalization rate (cap rate) is typically considered good, ranging between 4-12% in California, and can be a prevalent reason for a loss on the sale of rental property. When the cap rate is minimal due to high property costs or low rental income, it can erode the property’s profitability.
  4. High cost of repairs: When repair costs outweigh the potential increase in property value or rental income, you may want to sell at a loss to minimize your costs for ongoing repair expenses.
  5. Jump in property taxes: California’s property taxes are typically low, but local rates can change unexpectedly, potentially causing a loss on a rental property sale due to factors like policy shifts or rising property values.
  6. Major life changes: Life events such as marriage, divorce, retirement, or relocation can significantly impact a property owner’s priorities and financial situation.
  7. Avoid capital gains tax: Property owners may intentionally sell rental property at a loss to offset gains from other investments and reduce capital gains taxes, forming part of a broader tax strategy to minimize obligations and safeguard investment returns.

Can you write off the loss on the sale of an investment property?

A tax write-off can be applied when you sell an investment property at a loss, including rental properties, provided you meet specific qualifications. This tax benefit allows you to offset the financial setback by reducing your taxable income. 

An example of this would be if you sold stock and gained $50,000, you could sell a rental property for a loss of $50,000. This would set your capital gains tax to $0.

Is a loss on sale of rental property ordinary or capital?

According to the IRS, selling rental property at a loss typically results in a capital loss on a rental property. This classification holds true unless the property is considered inventory, in which case it would be an ordinary loss.

Capital losses often offer specific tax advantages, such as the ability to offset capital gains on rental property from other investments and even deduct up to a certain amount against ordinary income. 

However. the IRS does limit capital loss deductions. If your capital losses exceed your capital gains, you can only claim an excess loss of $3,000. If your loss is more than that, you can use a loss carryover to push it forward into another year.

As an example, let’s say someone sold a rental property at a loss of $7,000. They had no other capital gains or losses. They can claim $3,000 as a loss deduction for this year and save the remaining $4,000 for future years.

Calculating capital loss on rental property

Determining the capital loss on the sale of a rental property involves a straightforward two-step process: 

  1. Calculate the cost basis: Begin by evaluating how much you’ve invested in the property over time. This includes not only includes the property’s initial purchase price but also any capital improvements you’ve made, like a new roof or an HVAC system.
  2. Compute the capital loss: Next, deduct the cost basis from the sale price of your property while factoring in any tax-deductible expenses related to the sale. If this results in a negative number, you have a capital loss, potentially lowering your taxable income and allowing you to offset gains from other investments.

Here is a simple example to consider.

Mark and Amanda purchased an investment property in California for $500,000. They added some capital improvements that totaled $50,000. This gives the property a cost basis of $550,000.

While they had planned to keep the property for a long-term investment, their plans have changed, and they need to sell the rental quickly.

They accept an offer and end up with an adjusted sales price of $525,000. After subtracting the cost basis from the adjusted sales price, Mark and Amanda have a loss of $25,000. That loss can potentially be used as an investment real estate loss tax deduction.

Selling property at a loss tax implications

While a loss can be disappointing from an investing perspective, it carries potential tax benefits, particularly when considering the tax implications of selling investment property at a loss.

As we’ve briefly mentioned, capital losses can offset gains from other investments, reducing your taxable income and potentially leading to lower tax payments or refunds. However, complex rules and deduction limits apply.

If you sell a rental house for a loss, is it tax deductible?

Yes, if you sell a rental house for a loss, it can be tax-deductible. A loss on the sale of a rental property is considered a capital loss, and you may use it to offset capital gains from other investments, potentially reducing your overall taxable income. 

However, it’s essential to navigate the specific tax rules and limitations that apply to capital losses, which can vary based on factors like your tax bracket, the duration you held the property, and its use.  

Depreciation recapture on sale of rental property for loss 

When selling rental property, you may need to address depreciation recapture, even if it results in a loss.

Depreciation recapture entails repaying previously claimed depreciation deductions. While a capital loss may occur in the sale, the IRS can still recapture a portion of the depreciation claimed during property ownership.

The IRS allows investors to deduct depreciation, usually at 3.636% over 27.5 years. However, when the property sells for more than its depreciated value, depreciation recapture on rental property sold at a loss may apply.

For instance, if a property with a depreciated value of $475,000 is sold for $480,000, you might owe depreciation recapture tax on the $5,000 difference, irrespective of your cost basis.

Reasons selling a rental property at a loss isn’t tax deductible

While selling a rental property at a loss can be disappointing, it’s essential to understand that there are specific circumstances where you may be unable to deduct these losses for tax purposes.

The IRS categorizes rental losses as “passive losses,” in that they can only be deducted from passive income, such as income from real estate investments and other activities that require less than 750 hours of active participation each year. 

If you lack other sources of passive income, any losses from selling rental property may be suspended until you generate another passive income source. The passive loss carryover can be applied to future tax years.

However, there are two exceptions to the passive loss rules:

  1. You or your spouse are real estate professionals: If you spend over half of your working time on real estate business and properties, you are exempt from passive loss restrictions.
  2. Adjusted gross income is $100,000 or less: You can deduct up to $25,000 in real estate losses, provided you “actively participate” in the property’s management and have at least a 10% ownership interest. This allowance gradually decreases for incomes over $100,000 and is eliminated after $150,000.

Key takeaways on selling a rental property for a loss

As you can see, selling your rental property at a loss is a significant decision that can have far-reaching implications for your finances and tax situation.

It’s essential to recognize that while a loss on the sale of rental property may seem like a setback, it can also provide opportunities for optimizing your tax strategy.

For example, you can offset capital losses gains from other investments, potentially leading to lower tax liabilities or even refunds. However, these advantages come with complex rules, limitations, and exceptions that require careful consideration.

For any questions or assistance with selling a rental property in California, remember that SoCal Home Buyers is here to provide expert guidance and support, including information about a 60-day notice of intent to sell, or when and where to report sale of rental property. Feel free to contact us for a personalized consultation, ensuring that you have the information and resources needed to make the right choices for your real estate investments.

Feel free to contact us for a personalized consultation, ensuring that you have the information and resources needed to make the right choices for your real estate investments.

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Doug & Andrea Van Soest | SoCal Home Buyers

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