Tax implications for selling an investment property for a loss
Investor · Yorktown Heights, NY · Member since 2015 · 7 posts · 1 vote
Hi BP,
I bought a townhouse as my primary residence in 2006. Moved out in 2011 and converted it to a rental unit which I recently sold in 2015. My question is about how to treat the loss for tax purposes. I have a CPA that will be doing my taxes, but I just want to get a better understanding because I read so many different opinions on the topic.
My understanding is that the rental property is considered a Section 1231 noncapital asset. The loss is classified as an ordinary loss and is 100% deductible against my earned income.
I also understand that my basis is now the lower of my adjusted basis at the date of conversion or the fair market value at conversion. In my case the fmv at conversion was lower so this became my new basis. I ended up with about a $60,000 loss when it was all said and done.
Hoping that I am correct and can offset this loss against my ordinary income for 2015 as opposed to it being a capital loss that can only be offset against capital gains. Does anyone out there have any experience selling at a loss? Any help or guidance is much appreciated!!!
Thanks!
Here's how it works. First, it's important to understand that simply converting it to a rental will not grant you a loss. Your Section 1231 loss will be calculated on the original basis when placed into service as a rental.
This means that if your purchase a primary residence for $500k and later converted it to a rental, at which point the FMV was $200k, the new basis for the rental activity is $200k. If you later sell for above $200k, you will recognize a gain, not a loss.
Let's assume you understand the above and it applies to your situation. You will need to determine what your adjusted basis in the property is. Adjusted basis takes the original basis and subtracts from that the depreciation you've taken over the years as it was a rental.
You will then compare the sales price to the adjusted basis to determine the taxable gain or loss. Sometimes, you may sell the property for less than what you purchased it for but still have a gain as compared to the adjusted basis. At this point, you will pay depreciation recapture tax (Section 1250 Gain) at a 25% rate.
Example
In 2006 you purchase a townhome for $450k. You moved out in 2011 and rented out your primary home. Your adjusted basis when you placed the rental into service was $460k (since you made some improvements) and the FMV was $350k.
Because $350k is the lesser of the FMV and the adjusted basis, $350k becomes your basis for your rental activity.
In 2015, four full years later, you sell the property for $390k. While you believe you've incurred a $60k loss, you've actually incurred a $40k capital gain of which you will pay a 15% tax rate on. We use the basis when the rental was placed in service, not the basis of your primary residence purchase.
On top of that, you will pay depreciation recapture tax of $12,727 which is 25% of the depreciation you've taken over the past four years ($50,909)*.
*I assume a $0 land value for simplicity. Of course, taxes are never simple so this is not realistic :)
Here's how it works. First, it's important to understand that simply converting it to a rental will not grant you a loss. Your Section 1231 loss will be calculated on the original basis when placed into service as a rental.
This means that if your purchase a primary residence for $500k and later converted it to a rental, at which point the FMV was $200k, the new basis for the rental activity is $200k. If you later sell for above $200k, you will recognize a gain, not a loss.
Let's assume you understand the above and it applies to your situation. You will need to determine what your adjusted basis in the property is. Adjusted basis takes the original basis and subtracts from that the depreciation you've taken over the years as it was a rental.
You will then compare the sales price to the adjusted basis to determine the taxable gain or loss. Sometimes, you may sell the property for less than what you purchased it for but still have a gain as compared to the adjusted basis. At this point, you will pay depreciation recapture tax (Section 1250 Gain) at a 25% rate.
Example
In 2006 you purchase a townhome for $450k. You moved out in 2011 and rented out your primary home. Your adjusted basis when you placed the rental into service was $460k (since you made some improvements) and the FMV was $350k.
Because $350k is the lesser of the FMV and the adjusted basis, $350k becomes your basis for your rental activity.
In 2015, four full years later, you sell the property for $390k. While you believe you've incurred a $60k loss, you've actually incurred a $40k capital gain of which you will pay a 15% tax rate on. We use the basis when the rental was placed in service, not the basis of your primary residence purchase.
On top of that, you will pay depreciation recapture tax of $12,727 which is 25% of the depreciation you've taken over the past four years ($50,909)*.
*I assume a $0 land value for simplicity. Of course, taxes are never simple so this is not realistic :)
Thank you for the info!! Much appreciated!
If I did not have an appraisal done when I converted to a rental how can I justify the fair market value of the property at the time of conversion.
I did sell it below what I believe to be my adjusted basis. I am going to be as accurate as possible, but the fmv is just my opinion without any real evidence. Would you suggest I just look at comps that sold at the time I converted in 2011?
Do my chances of getting audited rise with a situation like this?
@Brandon Hall @Rich McCormack and other BP members.
I am in a very similar situation with my condo I purchased which was brand new construction in 2006 for $120k as a personal residence. We moved out and converted it to a rental in 2008 when the other units in the complex were still selling for around $110k used and $128k new. We refinanced it in 2011 to help it cash flow. It has never provided yearly cash flow and still doesn't with dropping rental prices in the complex, repairs, vacancy, HOA and PM fees. There is high turn over (average tenant stays less than 12 months) due to military members moving or deploying. I live too far away to self manage or do the repairs myself. The only units that have sold since 2010 were foreclosures or similar foreclosure prices. Currently the foreclosures are listed for about $80k, with some sold at auction for about $55-60k and we still owe about $95k. The foreclosure sale prices have always been about $15-25k less than our loan amount. Other owners we know are in same situation and either foreclose or rent at a loss every year. I used to think this property would eventually be able to be sold for what we owed, now I think that may not occur till the value drops significantly and the rent drops with it making it a cash flow and appreciation loser for years to come. Houses in the area have maintained or increased in price. The area has built condos every year so people are buying new condos all the time, but not used ones. I am looking to buy BRRRR properties in the near future.
It is currently rented. I don't want to foreclose. At 10 years old, I am sure there are more necessary repairs coming soon. When and how do you sell with the least amount of loss? How did the taxes work out Rich or anyone else with a similar experience?
I really wish I had BP (or a crystal ball) prior to 2006. Thanks for your advice BP members.
JP
Any licensed appraiser has access to a database with archival property value data that can be used to give you a retrospective appraisal to the month and year you converted your property to a rental.
hi all, new to BP and this is my first post. I am in the exact same scenario described by @Rich McCormak with the same dates, valuation, rental environment, converting at a lower FMV vs purchase price. Additionally, my income is now in the phase out level for claiming passive losses. I am able to claim about 50%. I have negative cash flow of 35%/$13k annually, under water by $20k, refinanced at 4.99% on a 30 yr fixed. I'm paying more than I owe b/c I don't see any way to get out of this until I have equity....but not sure it makes sense to take the depreciation recapture tax and a potential capital gains tax. Condo and HOA dues are 2/3 of the current negative cash flow
My question is about how closely the IRS looks into these situations. Does anyone know what elements get picked up by the IRS system and might trigger an audit? I understand the basis is the lower of the purchase price vs the fmv at time of conversion, but I just stumbled upon that while researching. What if I didn't know and I used my purchase price as my basis?