The truth is that losses on rental properties are ordinary losses, not capital losses. Because the loss on the sale of the rental properties is an ordinary loss, there is no limit to how much can be used each year to offset taxes.
Taxpayers may mistakenly show the loss on the sale of a rental property as capital loss because under the IRS rules, a gain on the sale of a rental is considered a capital gain.
So if you bought a property for $100,000 and sold it for $150,000, the $50,000 difference is taxed as a capital gain and is therefore subject to lower capital gains taxes.
Loophole:
- Selling a rental property for a loss – is treated as an ordinary loss.
- Selling a rental property for a gain- is treated as a capital gain.
An ordinary loss is better than a capital loss in two ways:
1. With an ordinary loss, there is no annual limit on how much can be used to offset your income
2. You can use an ordinary loss to offset your ordinary income, which is generally taxed at a higher rate.
Loophole for Investors: So yes, under the IRS rules, real estate investors can actually get the best of both worlds:
- If you sell a long term rental for a gain, you pay less taxes at the long term capital gains tax rates.
- If you sell a long term rental for a loss, you pay less taxes because the losses are considered ordinary.
Note: The capital gain and ordinary loss treatment on rental properties applies to all rental transactions, not just short sales or foreclosures.
So if you bought a property and sold it for a loss, you are probably looking at a big write off on your taxes in the year you sold the property.
Useful tips:
- Sale from rental property losses can be used to offset all active income, even your W2 or income from your business.
- Capital losses can only offset capital gains and if there are excess losses, you can take only $3,000 each year on your tax return. The rest needs to be carried forward into future years.
- There are no limits on the extent of ordinary loss that can be taken in a given year.