Can You Write Off Loss on Sale of Investment Property?

When an investment property sells for less than its adjusted cost, the resulting financial loss may offer tax benefits. Understanding the specific rules governing these losses is important for property owners. The Internal Revenue Service (IRS) provides guidelines on what qualifies as an investment property, how to calculate losses, and under what conditions these losses are deductible.

Defining Investment Property and Calculating Loss

An investment property is real estate acquired primarily to generate income or appreciate in value, rather than serving as a personal residence. Examples include rental homes, commercial buildings, or land held for future development. The purpose of ownership is key; if the main goal is earning a return, it typically qualifies as investment property for tax purposes. If a property is used for personal enjoyment for more than 14 days or 10% of the total rental days in a year, it may be considered a second home, impacting its tax treatment.

The concept of “basis” is foundational to determining gain or loss on the sale of any property. Basis represents the original cost of acquiring the property, including the purchase price and acquisition expenses like legal fees, title fees, and surveys. This initial cost is adjusted over the period of ownership, leading to the “adjusted basis.”

Adjusted basis accounts for various financial events that occur while you own the property. It increases with capital improvements, such as adding a room or significant renovations. Conversely, the basis decreases due to deductions like depreciation, which reflects the wear and tear of the property over time, and any casualty losses claimed. Accurate tracking of these adjustments is important because the adjusted basis directly affects the calculation of gain or loss upon sale.

To calculate the realized loss from the sale of an investment property, subtract the selling expenses and the adjusted basis from the sale price. The formula is: Sale Price – Selling Expenses – Adjusted Basis = Realized Loss. For instance, if a property sold for $400,000, had $30,000 in selling expenses, and an adjusted basis of $420,000, the realized loss would be $50,000.

Tax Treatment and Deductibility of Losses

Losses from the sale of investment property are typically treated as capital losses for tax purposes. A capital loss arises when a capital asset, such as investment real estate, is sold for less than its adjusted basis. In contrast, ordinary losses generally come from business operations or specific types of property, like Section 1231 property, which is used in a trade or business and held for more than one year.

Capital losses can first be used to offset any capital gains realized during the same tax year. If capital losses exceed capital gains, individuals can deduct a limited amount of the net capital loss against their ordinary income, such as wages. This deduction is capped at $3,000 per year, or $1,500 if married filing separately. Any net capital loss exceeding this annual limit can be carried forward indefinitely to offset capital gains or ordinary income in future tax years, subject to the same annual deduction limits.

For rental properties, passive activity loss (PAL) rules may further limit the deductibility of losses. Rental activities are generally considered passive, meaning losses can typically only offset income from other passive activities. If passive losses exceed passive income, the excess losses are suspended and carried forward until there is sufficient passive income or the entire interest in the activity is disposed of in a taxable transaction.

There are specific exceptions to the passive activity loss rules.

Real Estate Professional Status

Individuals who meet certain criteria regarding time spent and material participation in real estate activities can treat their rental income and losses as non-passive. This allows them to deduct rental losses against non-passive income, such as wages, without the usual limitations.

Active Participation Rule

Taxpayers may deduct up to $25,000 of passive losses from rental properties against non-passive income. This allowance begins to phase out for taxpayers with a modified adjusted gross income (MAGI) exceeding $100,000 and is completely phased out when MAGI reaches $150,000.

Losses on the sale of property to “related parties” are generally disallowed for tax purposes. This rule prevents taxpayers from creating artificial losses while effectively retaining control over the asset. Related parties include immediate family members such as siblings, spouses, ancestors, and lineal descendants. It also extends to entities where there is more than 50% direct or indirect ownership between the parties involved in the transaction. If a disallowed loss property is later sold by the related party to an unrelated third party, the previously disallowed loss may be used to reduce any gain recognized by the related party on that subsequent sale.

Reporting Investment Property Losses

When reporting the sale of an investment property and any resulting loss, specific IRS forms are required to accurately document the transaction. The primary form used is Form 8949, Sales and Other Dispositions of Capital Assets. This form details each sale, including the acquisition date, sale date, sale price, and adjusted basis, which leads to the calculation of the gain or loss.

The information from Form 8949 is then summarized and transferred to Schedule D, Capital Gains and Losses. Schedule D aggregates all capital gains and losses, both short-term and long-term, to determine the taxpayer’s net capital gain or loss for the year. If the investment property was a rental, its income and losses might also need to be reported on Schedule E, Supplemental Income and Loss, with passive activity limitations calculated on Form 8582, Passive Activity Loss Limitations.

The totals from Schedule D ultimately flow to the main tax return, Form 1040, impacting the taxpayer’s overall taxable income. Maintaining comprehensive records is important to substantiate the reported loss. This documentation should include purchase and sale agreements, closing statements, receipts for capital improvements, and depreciation schedules. These records support the adjusted basis calculation and provide evidence for the loss claimed on the tax return.