Is a Loss on Sale of Rental Property Ordinary or Capital?

When you sell a rental property for less than its purchase price, the resulting loss can be a valuable tax deduction. The tax treatment depends on several factors related to how the property was used and your specific financial circumstances. Understanding this distinction is important because ordinary losses are more flexible and can offset various types of income, while capital loss deductions are more restricted.

The character of your loss hinges on the property’s classification for tax purposes. This determination dictates how the loss will impact your tax liability, and navigating these rules correctly ensures you can properly account for the sale on your tax return.

Determining the Character of the Loss

When a rental property held for more than one year is sold, it is classified as “Section 1231 property.” This category includes real or depreciable property used in a trade or business, which covers most rental real estate activities. The tax treatment for Section 1231 assets provides a “best of both worlds” scenario depending on the net outcome of all such sales within a tax year.

The core of Section 1231 treatment involves netting all gains and losses from the sales of these properties for the year. If the final result is a net loss, it is treated as an ordinary loss. This ordinary loss is fully deductible against other forms of income, such as wages, without the annual $3,000 limitation that applies to net capital losses.

Conversely, if the netting of all your Section 1231 transactions results in a gain, it is treated as a long-term capital gain. This is also favorable, as long-term capital gains are taxed at lower rates than ordinary income.

An exception to this rule applies to individuals who are considered “dealers” in real estate. For a dealer, properties are viewed as inventory held for sale to customers in the ordinary course of business. In this situation, any loss on the sale is an ordinary loss, and any gain is ordinary income, without the special netting rules.

Calculating the Taxable Loss

To calculate your loss, the formula is the property’s sale price, minus any selling expenses, minus the property’s adjusted basis. Selling expenses include real estate commissions, advertising costs, legal fees, and other closing costs that reduce the net proceeds from the sale.

The most complex part of this calculation is determining the “adjusted basis.” You begin with the property’s original purchase price, which is its initial basis. This is then increased by the cost of any capital improvements made during your ownership. Capital improvements are significant expenditures that add value to the property or prolong its life, such as adding a new roof or a room addition, as opposed to simple repairs.

From this increased amount, you must subtract all depreciation that was “allowed or allowable” during the time you owned the property. This step is mandatory, and it reduces your basis even if you never actually took the deduction on your past tax returns. For example, if you bought a property for $300,000, spent $40,000 on a major renovation, paid $15,000 in selling expenses, and had $60,000 in allowable depreciation, your adjusted basis would be $280,000 ($300,000 + $40,000 – $60,000). If you sold it for $250,000, your taxable loss would be $45,000 ($250,000 – $15,000 – $280,000).

The Impact of Depreciation on Your Loss

Depreciation allows you to deduct the cost of a rental property over its useful life, which for residential rentals is 27.5 years. Each year you claim a depreciation deduction, you reduce your taxable rental income. However, these deductions also systematically decrease your property’s adjusted basis.

A lower adjusted basis means the calculated loss will be smaller or a gain will be larger when you sell. Section 1231 also has a “look-back rule” that can affect the character of gains. If you have a net Section 1231 gain in the current year, you must look back at the previous five tax years. If you claimed any net Section 1231 losses during that period, you must “recapture” the current year’s gain as ordinary income to the extent of those prior losses.

Applying Passive Activity Loss Rules

Even if the sale results in an ordinary loss under Section 1231, the Passive Activity Loss (PAL) rules may limit your ability to deduct it in the current year. For most taxpayers, rental real estate is a passive activity.

The PAL rules state that losses from passive activities can only be used to offset income from other passive activities. If your passive losses exceed your passive income, the excess becomes a “suspended loss” that is carried forward to future tax years. This limitation prevents taxpayers from using rental losses to shelter other non-passive income, such as wages.

A significant exception applies when you sell the property. Upon a complete disposition of a passive activity, all accumulated suspended losses from that specific activity are “released.” This means in the year of the sale, you can deduct the loss from the sale itself and all suspended passive losses from prior years against any type of income.

How to Report the Loss on Your Tax Return

Properly reporting the sale of a rental property at a loss involves a specific sequence of tax forms. You do not report the sale directly on Schedule E, the form used for annual rental income and expenses.

The primary form for this transaction is Form 4797, Sales of Business Property. This is where you will report the sale price, adjusted basis, and selling expenses to calculate the final gain or loss and perform the Section 1231 netting.

If you have suspended passive losses from prior years, you will use Form 8582, Passive Activity Loss Limitations. The sale of the property is a disposition event that allows you to release these suspended losses, and the form calculates the amount that can be deducted.

The final figures from both Form 4797 and Form 8582 will then flow to your main Form 1040. An ordinary loss from Form 4797 is reported on Schedule 1 of Form 1040, reducing your total income.