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Hello and welcome to Money Girl’s Quick and Dirty Tips for a Richer Life.

Today’s topic: Deducting a loss from the sale of a rental.

A listener called in with this question about how to deal with a loss from the sale of a rental property.

“Hello. I have a question. I am actually in the middle of a very bad investment. It’s a rental investment and I’m trying to sell it now even though the market’s not doing so well, but I just want to cut my losses. My losses are actually going to be above $25,000, which is the deduction that I could take. What happens when, say, it’s a loss of $50,000 and your AGI is under $150,000? Can you take $25,000 one year and then take the other $25,000 from the $50,000 loss the following year against your active income?”

Thanks for the question. First off, you’re not alone. These days, countless homeowners and rental property owners across the U.S. are unable to sell at a profit because of drops in real estate values in many locations. You practically can’t open up a newspaper without seeing stories about the problem.

Although we’d all like every investment to be a winner, reality is that not all of them are and sometimes taking a loss is a reasonable choice. Minimizing your losses is an important part of protecting your finances so that you can more easily grow your wealth in the future.

The tax implications of selling rental real estate, whether at a profit or a loss, can be very complex. Before selling a rental property, it’s really, really important to consult with a CPA who is an expert in rental real estate to find out what the tax impact is and what options you have in your specific situation.

In this episode, I want to give some general information about the tax implications of selling a rental.

The gain or loss from the sale of a rental is the amount that you realize from the sale (that is, the amount you receive after selling expenses) minus the property’s adjusted basis. If the number’s positive, that’s your gain. If it’s negative, that’s your loss.

When selling a rental house at a loss, the loss may actually turn out to be smaller than you’d expect. While you were renting it out, you were most likely depreciating the cost of the house on Schedule E. When you sell the house, your cost basis in the house is reduced by the amount of depreciation you’ve taken, which makes for a smaller loss.

A gain on the sale of a rental is taxed at the long-term capital gains tax rate (which is currently 15%), if you’ve held the rental for more than a year.

In contrast, a loss from the sale of a rental property is tax deductible as an ordinary loss. Ordinary losses are deductible in full against your ordinary income (like your wages and interest you earn, for example).

So a gain from the sale of a rental is taxed as capital gains, whereas a loss on the sale is treated as an ordinary loss. This is actually not a bad thing.

The situations is very different, however, when it comes to selling the home you live in (that is, your primary home) at a loss. Unfortunately, there is no tax deduction if you sell your primary home at a loss.

It’s kind of a subtle point, but the ordinary loss from the sale of a rental is not the same thing as a passive loss from operating and depreciating rental real estate. The $25,000 tax exclusion for rental real estate mentioned by the caller applies to passive losses from rentals. To find out how this nifty tax exclusion works and the income eligibility requirements, check out Episodes 25 and 27 of my podcast.

A really helpful resource when it comes to understanding the tax implications of owning rental real estate is the book Every Landlord’s Tax Deduction Guide  by Stephen Fishman.

And remember, it’s really important to meet with a CPA who’s knowledgeable about rental real estate when you’re considering selling, so you get custom-tailored advice about your options and the tax implications for your situation.

Lastly, I want to give away three copies of Andrew Horowitz’s book The Disciplined Investor. The winners are Mark in New York City, Tracy in Austin, and Dan in Memphis. Congratulations! Andrew kindly donated his book for the give-away. You can check out Andrew’s Disciplined Investor podcast on iTunes.

Cha-ching! That's all for now, courtesy of Money Girl, your guide to a richer life.

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As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.

Thanks for listening!

(1)     According to IRC section 1231, losses from the sale of rental real estate are ordinary losses