Loss on Sale of Rental Property: What Is Tax Deductible and What Is Not

A loss on a rental property sale is deductible as a capital loss, but the IRS may hold back how much of that deduction you can take in the year of the sale, and most landlords run into that restriction for the first time right after they close.

We’ve worked through enough of these situations to know where the confusion usually starts: the loss is real, and it still isn’t showing up as tax relief on that year’s return.

How the IRS Calculates Whether a Loss Exists

I usually start by walking through the adjusted basis before anything else in these conversations, and the number almost never matches what the seller has been tracking in their head.

For a property held a decade or longer, claiming depreciation each year pulls the adjusted basis down, and by the time someone is ready to sell, that adjusted basis is often substantially below the original purchase price.

Selling costs like commissions and closing fees reduce the gross sale price before it’s compared to the adjusted basis, and the deductible portion of those costs is a shorter list than most sellers expect.

Commission is the largest line on most closing statements, and the deductible portion also includes title fees and the seller’s share of escrow and transfer costs.

We went through which line items on the closing statement actually reduce the taxable gain in the closing costs and taxes guide, including where that deductible line falls.

When Selling Below Purchase Price Still Results in a Gain

A sale below the original purchase price doesn’t always produce a deductible loss, and that surprises sellers every time I explain it.

Depreciation taken during those years has already pulled the adjusted basis below the purchase price, and the number your CPA compares in the calculation is that lower figure, not what was originally paid.

We went through that full calculation, including how depreciation factors into the ending number, in the rental property capital gain guide.

If you’re asking about a primary residence rather than a rental, the IRS doesn’t treat those losses as deductible, and the same is true for a second home that was never used as rental property.

Why the IRS May Not Let You Use That Loss Right Away

Most of the landlords I talk to on this have no idea their rental qualifies as passive activity under IRS rules until the loss shows up on their return and their CPA has to explain why it isn’t reducing anything.

Under the passive activity loss rules from IRS Topic 425, losses from rental real estate generally can’t offset wages or active business income, and if no passive income from other sources exists to absorb the loss, the IRS defers the deduction to future years rather than applying it against that year’s taxes.

The IRS tracks suspended losses year over year, and a landlord can start using them once passive income exists to absorb them or once the rental property has been sold in full to an unrelated party.

I’ve had landlords sell with years of suspended passive losses and walk away with a substantial deduction in that same year, and it comes down to what the IRS calls complete disposition, where the seller transfers the entire ownership interest to someone unrelated to them.

The Income Threshold That Catches Most Landlords

Most landlords I talk to are above the income threshold where the active participation exception applies, and they usually don’t find out the loss hasn’t been coming off their return until it’s already built up.

If adjusted gross income sits above $150,000, the landlord can’t use the loss to offset ordinary income regardless of how actively they managed the property.

The landlords who reach me with suspended losses built up almost always crossed that threshold years back without anyone tracking what it meant for the rental deduction, and by the time the question comes up, they’ve been above the phase-out range for a while.

The $3,000 Annual Cap and What Carries Forward

Sellers sometimes expect a rental property loss to come straight off their wages, and the IRS classifies it as a capital loss rather than an ordinary one, with a different set of rules for how much can be deducted in a given year.

I’ve walked sellers through this one a lot: when the sale produces a net capital loss and there are no offsetting capital gains from other investments, the IRS caps the annual deduction against ordinary income at $3,000.

The cap is $1,500 for married filing separately, and unused losses beyond the annual limit carry forward with no expiration under IRS capital loss rules.

A landlord walking away from a rental with a $60,000 capital loss and no offsetting gains is looking at 20 years of $3,000 deductions against ordinary income unless capital gains from other investments exist to absorb the balance faster.

Depreciation Recapture on a Loss Sale

I’ve had landlords close on a sale for less than they originally paid and feel certain there was no tax exposure, and then their CPA calls to explain Section 1250 recapture.

Each year of depreciation reduced taxable income during the hold period, and the IRS recaptures some of that benefit at sale regardless of whether the overall transaction results in a gain or a loss.

De Carmen Drive, Colton

One seller we worked with owned a property on De Carmen Drive in Colton for about 30 years before we closed in May 2017 for $205,000.

The tenant had been there nearly as long, was behind on rent and hard to reach when we tried to schedule the walkthrough, and the owner had simply had enough after three decades of being a landlord.

The owner reached out looking for a clean exit without navigating the tenant situation or getting the property ready to list, and we gave them a close date that worked around their timeline without requiring either of those things.

The part that came up after we were in contract was the depreciation recapture question, and claiming those deductions over 30 years had moved the adjusted basis further than the seller expected.

Even on a sale that didn’t feel like a major profit, there was still recapture exposure their CPA needed to work through before filing.

Landlords who held a rental for more than five years almost always carry some level of recapture exposure into the sale, and under IRS Publication 544, the IRS taxes that portion at a rate capped at 25%, separate from whatever capital gains rate applies to the rest of the transaction.

Exceptions That Open the Door to Larger Deductions

I end up explaining two exceptions in most of these conversations: the real estate professional exception and the active participation exception, and for most landlords working a day job alongside a few rentals, neither one applies.

If you qualify as a real estate professional under IRS Publication 527, the IRS no longer treats your rental activity as passive, and qualifying requires more than half of your total annual working hours to fall in real estate trades or businesses, with at least 750 of those hours in real estate service during that year.

A landlord with one or two rentals and a full-time job in another field almost never reaches that threshold, and the IRS looks closely at how those hours are documented when someone claims the exception.

Under the active participation exception, landlords actively involved in management decisions and with adjusted gross income at or under $100,000 can deduct up to $25,000 of rental losses against ordinary income.

The IRS phases that benefit out completely once adjusted gross income exceeds $150,000.

The tax side of the sale is one piece of the decision, and for landlords still working through whether the timing makes sense, we covered the yield-on-equity and cash flow factors that go into that decision in the rental property timing guide.

Getting the Numbers Right Before You Close

Every rental property sale I’ve worked through has the same question at the center of it: whether the adjusted basis has been tracked correctly, including all the depreciation.

Call a CPA who has done rental property dispositions before you get to the closing table.

They’ll work through the depreciation history and the passive loss carryforward balance, and it’s the kind of review that takes an hour if the records are in order and much longer if they aren’t.

The IRS requires Form 4797 on every rental property sale and most individual sellers haven’t dealt with it before, and we walked through the reporting process in the sale reporting guide, including how the depreciation recapture piece shows up in the filing.

If you’re also working through the hold-vs-sell decision and want to know what a cash offer would look like for your rental property, call or text us at (951) 331-3844 or reach us through the offer page.

We buy rental properties across Riverside, San Bernardino, Los Angeles, Orange, and San Diego counties, and we can usually have a number for you within 24 hours.

About the Authors

Doug Van Soest spent seven years as a certified residential appraiser, starting in 2003, before co-founding SoCal Home Buyers with his wife Andrea in 2008. Together they have closed over 400 transactions across Riverside, San Bernardino, Los Angeles, Orange, and San Diego counties.

Andrea Van Soest, CA DRE #01505854, handles rehab project management, property listings, and the systems infrastructure for the team, and reviews closing statements on every transaction the company closes.