Selling Rental Property at a Loss: How the Loss Is Taxed

Figuring the loss

The gain or loss on a rental is the amount you realize (the sale price less selling costs) minus your adjusted basis. The adjusted basis is what you paid, with buying costs and improvements, less the depreciation allowed or allowable. Depreciation lowers the basis, so a property can show a loss for tax only if it sells for less than its depreciated basis, not just for less than you paid.

Take a rental bought in May 2021 for $400,000 plus $8,000 of costs, with 80% of the cost in the building, and sold five years later for $380,000:

Even though the price is below what the owner paid, depreciation turned the result into a $8,545.45 gain. The rental property capital gains tax calculator does this arithmetic for your property and shows whether you have a gain or a loss.

A section 1231 loss is an ordinary loss

IRS Publication 544 describes section 1231 transactions as sales and exchanges of real or depreciable property held longer than 1 year and used in a trade or business, reported on Form 4797. Whether a rental counts as property used in a trade or business depends on the facts of how you rent it; a tax professional can tell you for yours. When it does, you net all your section 1231 gains and losses for the year, and a net section 1231 loss is an ordinary loss. If the property is instead an investment held as a capital asset, the loss is a capital loss.

The difference matters because ordinary losses aren't subject to the capital loss limit. A capital loss offsets capital gains and then only up to $3,000 a year of other income ($1,500 married filing separately), with the rest carried forward. An ordinary loss can reduce wages, business income and other ordinary income in the year of the sale.

There is a catch for later years. If you have a net section 1231 gain in any of the next 5 years, it is treated as ordinary income up to your nonrecaptured section 1231 losses: the net losses of the previous 5 years not yet applied against a section 1231 gain. The ordinary loss now can turn a later gain from capital gain into ordinary income.

Suspended passive losses

Rental losses are generally passive, and passive losses you couldn't deduct in earlier years are carried forward. IRS Publication 925 says those losses are generally allowed in full in the tax year you dispose of your entire interest in the activity. Three conditions apply: you dispose of your entire interest, in a transaction in which all realized gain or loss is recognized, to a person who isn't related to you.

So a sale of a rental at a loss can produce two deductions in the same year: the loss on the sale and the suspended losses from earlier years. A sale to a relative, an installment sale or an exchange where part of the gain or loss is deferred changes the result, and an installment sale releases the suspended losses gradually.

A former home: the loss limit

You can't deduct a loss on selling a home you lived in until the sale. You can deduct a loss on a home you changed to rental use and were renting at the sale, but if the home was worth less than your basis when you started renting it, the deductible loss is limited. Publication 544 has the steps:

1. Take the lesser of the adjusted basis or the fair market value when you changed it to a rental.
2. Add improvements and other increases to basis since the change.
3. Subtract depreciation and other decreases to basis since the change.
4. Subtract the amount realized on the sale; if the amount realized is more, the result is zero.

The actual loss was $7,380.00, but only $2,380.00 is deductible: the drop in value while it was still a home isn't. The same lesser-of rule sets the basis for depreciation when a home becomes a rental, which the rental property depreciation calculator uses as its starting basis.

Before you sell at a loss

• Recompute the basis. Include buying costs and improvements, and subtract all the depreciation allowable, even any you didn't claim.
• Check your other section 1231 transactions. Gains and losses on other business property sold in the same year are netted with this one.
• Total your suspended passive losses. They come from earlier returns' passive activity worksheets, and a sale of your entire interest to an unrelated buyer can release them.
• Think about timing. A large ordinary loss is worth more in a year with more ordinary income, and a section 1231 gain in the following 5 years will be taxed as ordinary income up to this loss.

No depreciation gain, and how it is reported

A sale at a loss has no depreciation gain to tax. The unrecaptured section 1250 gain is figured as the smaller of the depreciation allowed or allowable and the total gain on the sale, so when there is no gain there is none of it either. The depreciation still mattered: it lowered the basis and made the loss smaller than the drop in price.

The sale of property used in a trade or business is reported on Form 4797, where section 1231 gains and losses are netted. Suspended passive losses are worked out on Form 8582, the passive activity loss form. If you also have losses limited by the at-risk rules or your basis in the activity, those limits apply before the passive loss limits, as Publication 925 explains.