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Can I Deduct Rental Losses On My Federal Income Tax?

Many of our clients at BlueSky own income producing real estate and our advisors are well equipped to advise them on a wide variety of related issues. In the following scenario, John Gjertsen, CFA, CFP®, EA, one of our senior wealth advisors, who participates in a consumer education on-line forum, answers a question from a young couple needing help sorting out their tax situation.

• They earn $1,595 per month in rent;
• They pay over $2,100 in mortgage, real estate taxes and association dues;
• Their home is worth approximately $200,000 and they owe $230,000.

They have over $16,000 in losses "on the shelf" from the prior four years. Rents are not rising, but every year their taxes and association dues rise. If they sold the home for $200,000 and owe $230,000, would that be considered a "loss" of $30,000? Does the $16,000 of accrued losses add to the $30,000 of losses?

If a loss, can they write it all off in one year, or is there an annual limit? They also carry over $3,000 of stock losses annually since 1999, and still have about $23,000 in stock losses remaining. What should they do?

John’s Response
There is an annual limit of $3,000 of net capital loss that is deductible each year; however, carryovers are allowed for the rest of your life. But if you sold the rental home, it’s not clear you have loss, at least as the IRS sees it. Your original basis in the rental was the fair market value on the date it went from personal use to rental use.

I’m not sure how many years it has been rented, but each year you should have depreciated the depreciable portion of this basis (excluding land), thereby lowering it. The gain (or loss) is the difference between the $200,000 you sell it for (net of commissions) and your depreciated basis. To the extent the basis is recaptured, the gain is ordinary income. Any gain over your original basis has preferential capital gain rates applied.

The fact that the property is encumbered by a $230,000 note adds not only to the complexity of your sale—as you probably need to look into a short sale or deed in lieu of foreclosure—but could potentially add to the tax bill. Forgiven debt is generally taxable, but residential rental property should qualify for an exclusion to this. See https://www.irs.gov/pub/irs-pdf/p4681.pdf