Tax implications for selling an investment property for a loss

[Rich McCormack]

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!

[Brandon Hall]

@Rich McCormack @George Roxby

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 :)