Very few people invest to lose money, but investment properties do periodically go wrong. When you or your business has to sell an investment for less than you paid for it, you could benefit from the IRS' relatively generous treatment of capital losses. However, there is more to calculating your loss than you might realize.
Capital Losses and Their Uses
When you realize a loss on your property, you can actually turn it around to your advantage. The IRS lets you use your capital losses to offset your capital gains. In other words, when you sell your property for less than you originally paid for it, you can sell a different investment on which you made a profit and have the loss and profit cancel each other out. In fact, you could sell appreciated stock, wait 30 days to meet the IRS' "wash rule" requirements, then re-buy it with a new, higher basis.
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If you don't have any appreciated assets to sell, you can write off up to $3,000 in losses per year against other income. If you can't use all of your losses in the year you sell your property, you can carry the loss forward to subsequent years until it gets used up.
Depreciation Recapture Tax
When you sell real estate that you paid $1,000,000 for and you get $800,000, you'd think that you had a $200,000 loss. However, it's also possible that you actually realized a gain. This happens because, when you sell the property, the IRS subtracts all of the depreciation that you claimed against the building from your cost basis. In other words, if you paid $1,000,000, but you claimed $300,000 in depreciation while you owned the property, your actual cost basis would be $700,000. You'd have to pay federal depreciation recapture tax, which is set at 25 percent, on the $100,000 profit over your depreciated basis.
Taxes and Debt Forgiveness
If your property sold for less than the amount that you owed your lender and your lender agreed to forgive the shortfall, the amount of your mortgage debt that they cancelled is taxable. Although the government passed the Mortgage Debt Forgiveness Act in 2007 to eliminate taxes on mortgage reductions, it only applies to sales of personal residences. It does not apply to the sale of commercial or investment properties. There are exceptions, though, so this is an area where it's especially important to talk to a tax adviser who can assess your situation.
If you bought your property through a 1031 tax-deferred exchange, your cost basis is not the purchase price. It's the basis you carried forward plus any new money or debt that you put into the transaction. In most cases this means that you paid less for the property than its purchase price would indicate. This frequently leads to you having capital gains liability, even if you don't expect it.
The way to get out of this problem, or to get out of having too much accumulated depreciation, is to do a 1031 exchange when you sell. This way, you carry your basis forward into the new property and avoid paying capital gains or depreciation recapture taxes.