Selling Rental Property at a Loss (Depreciation Recapture & More)

Investing in real estate in California can lead to good profits. However, there are always risks involved with real estate investments. One of those risks is the property losing some of its value and becoming more than you care to deal with.

If you own a rental property that’s becoming a drain on your finances, you might be considering selling a rental property at a loss. While this may initially seem like something you shouldn’t do, it isn’t all bad news. Selling rental property at a loss does have some advantages.

We’re going to look at some of those benefits and how you can navigate selling investment properties at a loss if it’s a serious consideration.

Concerned About Selling Rental Property at a Loss?

You can sell any house you own at any time, whether for a gain or a loss. However, if you own investment property, there are certain times and situations when selling at a loss could be better for you.

If you’re unsure of your investment strategies or tax situation, we recommend talking with a professional, like a real estate agent, lawyer, or accountant, who can give you the best, personalized advice.

Common Reasons for a Loss on Sale of Rental Property

While your circumstances will vary greatly depending on your investment situation, here are some of the most common times to sell a rental property at a loss:

Dropping Rent Prices: If rent prices are starting to fall, you could cut your losses early and sell. If you wait, prices might continue to drop, you may struggle to find tenants, and your losses may compound.
Boom of New Construction: If developers are planning new construction in your area, especially rental housing, this can lead to a flood of available rental properties, lower demand, and lower rent. Keep an eye on housing construction projects to consider how they would affect your investments.
Low cap rate: You likely calculated a cap rate when you initially purchased your
investment property. This rate indicates how much of a return you could expect.
In areas with high rent prices, like here in California, a 4% cap rate is
considered good. If you recalculate your cap rate and see it trending down, it
may be beneficial to sell at a loss now before it drops too low.
High cost of repairs: If your investment property needs expensive repairs, like new
appliances, a new roof, and other maintenance problems, selling at a loss could
outweigh the cost of having to pay for those repairs yourself. Selling to home investors could be an easy way out.
Jump in Property Taxes: While California in general has low property tax rates, local rates can change overtime. If you know a rate hike is coming, you can sell at a loss before you have to pay those higher taxes.
Major Life Changes: One reason many people considering selling an investment property at a loss is because of a major life change, like a divorce, death in the family, or out-of-state move.
Avoid Capital Gains Tax: When you sell an investment for a profit, that profit is typically subject to the capital gains tax. This rate could be as high as 20%, depending on your tax bracket for the year. By selling at a loss, you can potentially avoid high capital gains taxes.

How to Calculate Capital Loss on Investment Property?

Calculating your potential loss on a sale of an investment property can be done in just two simple steps.

Calculate how much you have invested in the property, called the cost basis. This includes the initial purchase price plus any capital improvements you made, such as a new roof or air conditioning system
Take the sale price of your property, less any tax-deductible expenses, and subtract the cost basis. If the answer is a negative number, this would be a capital loss.

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.

Offset Capital Gains with a Loss

Some investors use a strategy called tax loss harvesting. This involves offsetting a capital gain with a loss, so you do not have to pay taxes on your capital gains.

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.

Consider a Loss Carryover

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.

Effects of Depreciation Recapture

One consideration for selling property at a loss is depreciation recapture. The IRS allows investors to deduct a certain amount of depreciation from their taxable income. Most U.S. properties use a depreciation rate of 3.636% over 27.5 years.

You can deduct 3.636% of your basis in the property each year. However, when you sell the property, even at a loss, you may have to pay a depreciation recapture. This happens when the property sells for more than its depreciated value.

For example, if you reported a rental property with a depreciated value of $475,000, but then it sells for $480,000, you may have to pay a depreciation recapture tax on the $5,000 difference, even if your cost basis was higher than the sale price.

Why Can’t I Deduct my Rental Property Losses?

There are certain circumstances where you will be unable to deduct your rental property losses. The IRS considers rental losses as “passive losses.” Passive losses can only be deducted from passive income, not the income you earn from a full-time job or other active income streams.

Passive income is income from real estate investments and other activities that require less than 750 hours of your active participation each year. If you do not have any other sources of passive income, your losses from selling rental property are suspended until you have another source of passive income.

The passive loss carryover on your rental property sold can be applied to future tax years.

There are two exceptions to the passive loss rules:

You or your spouse are real estate professionals.
Your income is low enough to take advantage of the $25,000 annualrental loss allowance.

If you’re a real estate professional, you’re completely exempt from passive loss. However, you must spend over half of your working time with your real estate business and properties. It requires at least 751 hours a year.

If your adjusted gross income is $100,000 or less, you can deduct up to $25,000 in real estate losses. However, you must “actively participate” with the property. This means you help make management decisions and have at least a 10% ownership interest in the property.

This allowance gradually declines with an income over $100,000 and is eliminated after $150,000.

Final Points on Selling Investment Property at a Loss

Selling a rental property in California at a loss can have significant financial consequences, and it is important to carefully consider all factors before making a decision.

It’s important to weigh the long-term financial effects, assess current market conditions, consider alternative options such as renting out the property for a longer period or making repairs/renovations, and consult with a financial advisor or tax professional for guidance on the tax implications.

Ultimately, the decision to sell a rental property at a loss should be based on your overall financial goals and risk tolerance. It’s important to remember that there is no one-size-fits-all answer and it’s critical to make a decision that is best for your specific situation.

Frequently Asked Questions

The IRS considers a sale of rental property at a loss as an “ordinary loss.” You may be able to claim up to $3,000 in losses if you do not have gains to offset an additional loss amount. You can carry forward loss on a sale of rental property to future years when you do have more capital gains to offset.

The IRS allows a deduction of up to $25,000 for rental property losses as long as your modified adjusted gross income is less than $100,000. You must be an active participant in your rental investments to qualify for this deduction. You cannot deduct any rental losses if your income is over $150,000. There are no limits on rental losses if you’re a real estate professional.

A tax “write off” is the same thing as a tax deduction. Yes, you can write off a loss after the sale of a rental property if you meet certain qualifications.

If you need to sell your personal residence, but realize you could take a loss, one option is to convert it into a rental property. Any capital loss you experience during the sale of personal residence is never tax deductible. However, if you convert your property into a rental property, it could yield tax benefits in the future.

A residential investment property is considered a section 1231 property by the IRS. A section 1231 property is a business property that was held for more than one year. Rental property not included in section 1231 is single-tenant triple-net property.

This is property that’s leased 100% to a single tenant and that tenant is responsible for all property expenses. If you’re unsure if your property qualifies for section 1231, you should consult with a real estate or tax professional.

When you sell a section 1231 rental property for a loss, you will report that loss when you file your federal and state taxes. In your federal tax return, this is done using Form 4797, Part I.

When businesses experience a loss, it is typically considered a capital loss and is limited to a deduction of $3,000 a year. However, with section 1231 property, losses are considered an ordinary loss and you can deduct the entire loss amount in the same year.