Tax Loopholes in Selling Rental Properties

The home price declined sharply in recent years, after the biggest real estate bubble had burst and many home owners lost equity in their homes. The real estate market, especially in California, may take longer than other states to recover its peak value equal to 2006.  However, with low home prices and interest rates, owning real estate is potentially a good investment and a great tax saving tool, depending on your income level.  Most of the people are familiar with tax advantages of selling a principal residence. The IRS code, Section 121 provides the exclusion amount of up to $500,000 (for married filing joint) of gain from the sale of a residential property if the property was used as a principal residence for at least 2 out of 5 years.  Also, the interests and property taxes paid are tax deductible.  However in this column, the focus will be on the sale of rental properties, which is more complicated and unfamiliar then the sale of a principal residence.

Rental property held for more than a year and sold for a gain:

If you had a rental property for more than a year and sold it at a gain, then your gain would be taxed at two different tax rates. Your gain will be taxed, first, at an ordinary income tax rate up to 25% to recapture your depreciation expense that you have taken out over the years and the rest would be taxed at a lower long term capital gains tax rate.  Let’s say that you purchased your rental home 10 years ago for $200,000 and have taken out a depreciation expense of a total of $50,000, then your basis in your property is $150,000 ($200,000 – $50,000). If you sold this property for $250,000, then your total gain would be $100,000 ($250,000 – $150,000). Out of the $100,000 gain, the first $50,000 would be taxed at an ordinary tax rate up to 25% and the other $50,000 would be taxed at 15% long term capital gains rate.

Rental property held for more than a year but sold for a loss:

Don’t feel too badly if you sold your rental property at a loss, which is not so uncommon now days.  If you had your rental property for more than a year and sold it at a loss, then unlike capital loss which only allows a $3,000 deduction against your ordinary income, you could offset your entire loss against your ordinary income which would lower your tax liabilities and possibly get you more refund. But here is the best part of it, you could carry back your loss for two years and get the refunds for those two years that you paid taxes if your loss is big enough to wipe out the current income to zero.  After you reduce your current income to zero and carry your loss back for 2 years and still have a loss from the sale of the rental property, then you can carry forward your loss for up to 20 years which will reduce your future taxable income.  Nobody wants to sell their rental properties at a loss, but if it does happen (which is quite common now days), please talk to your CPA to find the great tax saving advantages from it.

Principal residence turned into rental property and sold it at a loss:

This current bubble created the biggest loss of equity in homes nationwide and California is the worse compared to other states.  Many home owners try to sell their principal residences for a long time, and then finally give up selling it.   Instead, they decide to rent it and wonder if they could deduct the loss if they finally sold their rental properties below the purchase price of their principal homes.  Generally, a loss from the sale of a principal home is not tax deductible, but once it is converted to a rental property and the value declines further after the conversion to a rental property, then the loss could be deductible when the property is sold.  For example, if you purchased your principal residence at $600,000 in 2005, but you decided to convert it to a rental property in 2009 after several failed attempts to sell it.  The basis for your rental property is the lower of the costs or the fair market value at the time of conversion, so, if the market value has declined to $250,000, then your basis is $250,000 (not $600,000).  Assume you have taken out $20,000 of depreciation expenses from 2009 ~2011 and sold your home for $200,000, then your loss is $30,000 ($250,000 – $200,000 – $20,000).

Rental property turned into principal residence and sold it at a gain:

This is the mirror image of the example above.  If you have a large appreciation in your rental home, then there is a great tax advantage for converting it to your principal residence and then sell it because of $500,000 exclusion explained above. But, there are conditions and limitations that must be carefully considered.  As I explained above, the depreciation expenses that you have taken out throughout previous years must be recaptured as an ordinary income which would be taxed at a maximum 25%.  The rest of the gains would be treated as a long term capital gains but, up to $500,000 (for married filing joint) would be exempt under Section 121 of the IRS code if the property was used as principal residence for at least 5 years or may have to allocate the gains between qualified use and nonqualified use. The nonqualified use portion of the gain would be not excluded under Section 121.

Conclusion:

In general, if you have a rental property, you should consult with your CPA.  As the examples above show, the plan you make for that property can be beneficial to you or detrimental to you.  Please remember, that every year you could deduct up to $25,000 of loss from your rental activities against your ordinary income, if your income is below a certain threshold.  If you are making above that threshold, then you are not allow to deduct that loss against your ordinary income, but carry it forward to the next year until you have a positive rental income.  The rental loss could be accumulated and may not help you lower your overall income tax liability now, but you can free up this loss when you sell this rental property in the future.

If you have questions, need additional information or would like to discuss more on the above topic, please feel free to call us and/or visit our office.