If you have to sell your South Florida rental property eventually, you’ll want to sell it at a profit – after all, who would want to sell it for less? However, when the market takes a downturn, you’ll have no choice but to accept the loss – fortunately, not at a complete loss. You may be able to subtract your loss from your taxable income.
In this article, we’ll go over the basics of what to expect when you sell your rental property at a loss, as well as its effect on your taxable income.
How Do Investors Make Money From a Rental Property?
There are two ways that you can profit from the ownership of South Florida rental property:
Ordinary income refers to the profit (or loss) once the expenses have been subtracted from the rent (i.e. the monthly rent you collect from tenants). Residential real estate owners use the IRS Schedule E (Form 1040) to report the income received on a real estate investment every year. Rental income is taxable, but it varies between 10 to 37 percent.
There are two types of capital gains: long-term capital gains and short-term capital gains.
Long-term capital gains (or losses) are generated when the rental property is sold after it’s been “held” by the property owner for more than one year. Residential real estate owners use Schedule D (Form 1040) to report their capital gains (or losses) to the IRS. Like ordinary income, capital gains are also taxable by about 0, 15, or 20 percent.
Short-term capital gains are similar to long-term capital gains, but they pertain to properties that are sold within one year of ownership. A common example of this is a “fix-and-flip” type of property, where the owner sells the property within a short period of time. In this case, the short-term gain (or loss) is considered ordinary income.
What to Do When You Lose Money When Selling Your Rental Property
No one South Florida property owner wants to sell their property for a loss, but it’s a possibility. When you sell your rental property for a profit, that profit goes into your Schedule D as capital gains (as the name suggests, you gained from the sale). However, if you sell your rental property at a loss, that loss can be deducted from your income. This, however, comes with certain limitations, so be sure to consult real estate professionals from a reputable property management company.
How to Calculate Your Losses
Calculating the loss isn’t as simple as it seems. You can’t simply deduct the sale of the property from the cost to purchase the property. You need to be able to calculate the cost basis first.
What Is the Cost Basis?
The cost basis, or the “basis”, is the amount of money you paid to purchase the specific property. It also considers the closing costs, as well as the costs for any improvements you made to your real estate investment (not covering maintenance costs). Improvements pertain to those that increase the value of your property, such as an HVAC, roof, etc.
For instance, if you purchased a rental property for $120,000 with $6,000 in closing costs and $10,000 in upgrades, then your cost basis would be $136,000.
Subtracting the Cost Basis From the Sale Price
Once you’ve calculated the cost basis, you can subtract it from the sale price. This is the amount of money that a person paid for your South Florida rental property.
Let’s say that you sell your rental property for $100,000. To calculate your loss, you subtract the cost basis from the sales price. In this case, if your cost basis is $136,000 and your sales price is $100,000, your loss would be $36,000.
We know it looks bad, but that $36,000 can be claimed as a tax-deductible from your taxable income!
How to Offset Capital Gains Using Losses
If you have a capital gain from another investment that’s sold in the same year, you can offset it using the loss from another sale. This is also called tax-loss harvesting, and this strategy can help you improve your real estate returns.
Let’s say you have a real estate investment that you sold for a loss of $36,000 and another real estate investment that you sold for a gain of $36,000. In this example, the taxable amount would total $0. However, if your losses exceed your gains, you can “carry over” the excess amount to the next year.
What is Depreciation Recapture?
But wait! Before you subtract your losses from your income, remember that you may still owe taxes on your rental property due to the depreciation recapture.
Depreciation is one of the tax deductions you can benefit from, but if you sell your rental property, the IRS needs you to “recapture” the depreciation for it to be taxed.
To understand how depreciation recapture works, let’s say that in the years after you purchased a $100,000 rental property, you were able to claim about $4,000 as depreciation deductions. When you sell the property, you will still owe 25% of that amount, which is $1,000 (but this depends on your tax bracket, so be sure to ask a real estate professional).
Can You Convert a Residence Into a Rental to Claim a Loss?
Some property owners convert their primary residence into a rental property so that they can claim a loss. However, while this is possible, it should be mentioned that the loss can only be calculated from the point the property was considered a rental property.
For instance, let’s say you purchased your primary residence for $300,000 but your market isn’t the best, so now its value is at $280,000. When you convert it into a rental property, your cost basis is based on the new value of $280,000 and not the purchase price of $300,000.
Always Consult a Real Estate Professional
As you may have observed, tax deductions can be complex. The IRS outlines the basics of tax deductibles on their website, but even if you have that knowledge base, it can still be a challenge to figure out by yourself. That’s why you should always consult a real estate professional.
By partnering with Luxury Property Care, not only will you have a team of in-house accountants and real estate lawyers, but you can also make sure that you do the correct deductions. That way, you won’t get in trouble when it’s tax time.