Facing a Loss at Sale? Consider the Tax Benefits of Becoming a Landlord.
Q: A year and a half ago when the market was hot, we purchased a home in Virginia that we thought would be ours for a long time. However, I have been transferred to the West Coast, and we are now facing a loss when we sell our home. Fortunately we do not think we will have to come up with cash to sell it because we made a large down payment.
If we had made profit on the house, I understand, the IRS would allow us some partial exclusion of that gain, even if we had not owned the house for a full two years. Can we deduct all or even a part of our loss?
A Unfortunately, the answer is no. The Internal Revenue Code does not allow deduction of losses on personal residences.
There are, however, some circumstances in which you might still have a deductible loss.
Did you use some of your house for business or rental purposes? If so, that portion can be deducted because it is not a loss related to a personal asset.
Another exception is for principal residences that are converted into rental property. Here is where you may be able to limit your loss if you don't need to sell the house right now.
Many people do not like to own rental property, especially when they don't live nearby. However, you should talk with your tax advisers about this possibility.
How does this work? First, remove all evidence that this remains your principal home. Change your driver's license and your voting registration. If you are getting some tax benefit for your main home -- such as the homestead exemption in the District -- advise the real estate tax office that you no longer are eligible for this tax reduction.
Because you will be living far away, you probably will want to hire a property manager to collect the rent and deal with the tenants. This is an additional expense to include in your calculations. While you may be willing to have a reasonable negative cash flow, you obviously want to make sure that your income will be high enough to support this loss.
I believe the real estate market will rebound, but I haven't a clue as to when this will happen. With luck, within two or three years, the market value of your house will have increased, in which case your overall loss will be less than if you sell now. And whatever the loss, you may be able to deduct it on your income tax return.
"You actually have to rent out the home before you can take a loss deduction," according to "The Home Seller's Guide to Tax Savings," by Julian Block. "This limitation has been upheld by the courts."
In other words, it is not sufficient to give a real estate agent a listing or place a "for rent" advertisement in your local newspaper. If you cannot rent the house, you cannot take any deduction for your loss.
The Internal Revenue Service follows what is known as the "two-year old and cold" rule. If you rent the house for just one year, the IRS may still consider the house to be your principal residence. However, if you rent for two or more years, the categorization of it as your principal residence becomes "old and cold."
Nothing is easy when the IRS is involved. When you sell, how do you determine the amount of your loss for tax purposes? According to the IRS, you calculate loss beginning with the property's value as of the date that you converted the house into rental property, not as of the date you purchased the house. The full formula, which takes into account depreciation and improvements, is complex. For details, see IRS Publication 544, "Sales and Other Dispositions of Assets," available on the Web at http:/
You should have an accountant or tax adviser assist you in calculating the loss, but the IRS provides a helpful example:
Five years ago, you changed your principal home to a rental property. At the time of the change, the adjusted basis was $75,000, and the fair market value was $70,000. This year, you sold the house for $55,000. Over the years, your depreciation was $12,620. Using the IRS formula spelled above, here is how it works:
· Lesser of adjusted basis or fair market value at time of change: $70,000
· Plus cost of any improvements: None
· Subtract depreciation of $12,620; that equals $57,380.
· Then subtract the $55,000 realized from the sale. Your deductible loss would be $2,380.
To complicate things even more, the law also limits the amount of the loss that can be deducted each year.
You can offset capital losses against capital gains, Block pointed out in an interview. "But in the absence of capital gains, the yearly cap is $3,000 -- $1,500 for those filing separate tax returns -- on the amount of losses they can offset against their 'ordinary income.' The law does, however, allow taxpayers to carry forward unused losses to later years."
This "convert to rental" scenario is worth considering, but before you take any steps or sign any contracts, make sure you understand the tax laws. Expert advice is necessary.
Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, www.kmklawyers.com.