Tax Breaks for Losses on Rental Property Sales

In this tough economy, you may own a piece of rental real estate that you now need to sell -- maybe for a loss. While loss sales were pretty unusual a few years ago, they unfortunately happen all the time now. But it isn't all bad news. Losses you incur from unloading investment properties can receive very favorable tax treatment. Here’s what you need to know.

A tax loss occurs when you sell your property for less than its tax basis -- which generally equals the price you originally paid, plus the cost of improvements over the years (it does not include any repairs you took tax deductions for along the way) minus all the depreciation write-offs claimed during your ownership. So if you’ve owned the property for a long time, its tax basis may be a lot lower than you think as a result of the depreciation factor. Therefore, you might trigger a tax gain if you sell even though it may “feel” like a loss because you sold at such a low price. (Sadly, though, the IRS doesn’t care about your feelings.)

The tax basis of a property that you sell might also be a lot lower if you acquired it in exchange for another property in a tax-deferred “Section 1031" swap (also called a like-kind exchange). In this case, your initial tax basis in the property was reduced by the amount of gain that you deferred in the Section 1031 exchange. So if you deferred a large gain, the basis reduction was a large number, and selling the property could actually trigger a tax gain instead of the tax loss you might have expected.

Bottom Line: Make sure you know what your property’s tax basis really is before selling. You don’t want to be mistaken and trigger a tax gain without knowing about it ahead of time.

If you have a tax loss on a property you've owned for over a year, then you have a “Section 1231" loss. This is the best kind of loss you can have because you can deduct it against any and all types of income (salary, interest, dividends, capital gains, alimony received, self-employment income, whatever). If your Section 1231 loss is large enough to exceed your 2009 taxable income (calculated before the loss), it may even create a net operating loss (NOL).

NOLs are handy because you can carry the loss back for two years and recover some or all of the taxes you paid back in 2007 and/or 2008. Alternatively, you can choose to carry the NOL forward for up to 20 years, to 2010 and beyond, and use it to offset income that might be taxed at higher rates (possibly much higher rates) in those years. There’s also a possibility that Congress might extend a temporary break that allowed many taxpayers to carry back their 2008 NOLs for up to five years (instead of the usual two). If that happens, you could carry back a 2009 NOL to as early as 2004.

As a real estate owner, you’re probably aware of the dreaded passive loss rules. If they applied to you in previous years, some or all of your rental real estate losses may have been deferred (suspended) for tax purposes. You generally cannot deduct those suspended losses until you either have positive taxable income from your rental real estate activities or until you sell the property (or properties) that generated the losses in the first place. So if you now sell a property that generated suspended passive losses, those losses might suddenly become deductible on your 2009 Form 1040. And if those suddenly deductible losses are big enough, you might create or increase a 2009 NOL that you can then carry back to prior years or forward to future years with tax-saving results.

The rules for suspended passive losses can be tricky if you own multiple rental properties. If you do, consult your tax advisor to find out whether selling a particular property will allow you to deduct some suspended passive losses.