Real Estate Loss Deduction for Individuals

In the last ten years, too many taxpayers have sold real estate at a loss. How does this type of loss ultimately affect the amount of taxes owed to the IRS? First, to accurately determine the amount of a loss from disposition, compare the property’s sale price to its tax basis. The tax basis is generally the original purchase price, plus the cost of improvements (but not expenses deducted as repairs and maintenance) less depreciation.

Internal Revenue Code Section 165(a) is the principal code provision that enables taxpayers to claim deductions for losses. § 165(c)(1) limits the types of losses that can be deducted against gross income to those from:
• a trade or business;
• activities engaged in for profit;
• sales and exchanges of capital assets;
• casualty losses (destruction of property by fire, storm, or shipwreck); and
• property theft.

§ 1231 of the tax code applies to gains and losses from the sale or exchange of ordinary property or a capital asset held for more than one year and used in a trade or business; and the compulsory or involuntary conversion (from destruction, theft, seizure, or government condemnation) of either type of property used in a trade or business. Net gains from the disposal of Section 1231 property are categorized at capital gain rates, while net losses from the disposal of Section 1231 property are taxed as ordinary losses. If total Section 1231 gains exceed losses for the year, then all gains and losses are capital. If total losses exceed gains for the year, then all gains and losses are ordinary.

§ 1231 losses can be used to reduce any type of income like salary, bonus, self-employment income, or capital gains. If you have a net operating loss (NOL) because the § 1231 loss is great enough to reduce your other income below zero, you can carry back the NOL for at least two years to offset taxable income in those years by amending the original returns. If any of the NOL is left over after going back two years, you can carry the remainder forward into future tax years to offset future income for up to 20 years. Of course, you can choose to only carry it forward for the 20 year period if this is your preference.

Rental property that has generated losses in past tax years may have suspended passive activity losses (PALs), which may only be deducted against passive income, i.e., that from other passive business activities and rentals. Suspended PALs may be deducted when the property is sold that generated them. If you sell a rental property with suspended PALs, you may be able to deduct them on top of deducting any § 1231 loss from the sale. Like § 1231 losses, deductible PALs can also create or increase an NOL that you can carry backward or forward.

In most cases, rental real estate activities are generally passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services. Deductions or losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities.

If you have questions about real estate loss deductions and passive activity limits, call THE TAX EXPERTS at the Thorgood Law Firm For a FREE consultation, call 212-490-0704.
Real Estate Loss Deduction for Individuals

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