This article will look at how rental property losses work and discuss why an investor may still need to pay tax even when selling their properties for less than what they initially cost.
Most investors don't purchase a home with the goal of realizing negative cash flow from its sale. However, despite our best efforts, sometimes rentals turn out poorly enough that we lose money on them - occasionally even way more than was originally invested! Despite being an unappealing idea in itself (and thankfully rare), there can actually be some benefits if you manage your costs correctly. Let's take this opportunity to learn about calculating those deductions before deciding whether or not to give up on your current money-losing rental property.
When you lose money on the sale of a rental property, it is classified as a capital loss. Capital losses can be used to offset any other capital gains you may have realized during the year, and if your losses exceed your gains you can deduct up to $3,000 per year against your ordinary income. Capital losses can also be carried forward indefinitely to offset future capital gains.
To figure out your loss, you'll need to know two things: your basis in the property and the proceeds from its sale. Your basis is generally what you paid for the property plus any money you've put into it over the years through improvements and repairs (less any depreciation you've taken). The proceeds from the sale are simply how much money you receive from the buyer. This will be lower than your basis if you lose money on the deal.
Once you have your basis and proceeds, calculating your loss is pretty straightforward:
For example, let's say you purchased a rental property for $100,000 and put another $20,000 into it over the years in repairs and improvements. You depreciated the property by $5,000 during that time. When you go to sell the property, you only receive $90,000 from the buyer. In this case, your loss would be:
Loss = Basis - Proceeds
Loss = $100,000 + $20,000 - $5,000 - $90,000
Loss = $35,000
This $35,000 loss can be used to offset any other capital gains you have for the year, and if it exceeds your gains you can deduct up to $3,000 of it against your ordinary income. If you have no other capital gains for the year (or your total capital losses exceed your capital gains), you can carry the loss forward indefinitely to offset future capital gains.
One thing to keep in mind is that if you're selling the property at a loss because you're being foreclosed on, or because you agreed to a short sale with the bank, the IRS may consider the loss to be "phantom income" and tax you accordingly. In these cases, it's best to speak with a tax professional before taking any action.
While no one wants to lose money on a rental property, there can be some benefits to selling at a loss if it makes sense for your overall portfolio. Just make sure you understand the tax implications before making any decisions.
****We are not financial advisors. The content on this website is for educational purposes only and merely cites our own personal opinions. In order to make the best financial decision that suits your own needs, you must conduct your own research and seek the advice of a licensed financial advisor if necessary. Know that all investments involve some form of risk and there is no guarantee that you will be successful in making, saving, or investing money; nor is there any guarantee that you won't experience any loss when investing. Always remember to make smart decisions and do your own research!