Can you get a tax break for selling your house at a loss?

If you’re hoping for a tax break for selling your house at a loss, the rules will probably disappoint you. In most cases, the IRS doesn’t let you deduct the loss if you sell your primary residence for less than you paid. But don’t stop reading here because a few exceptions to the rule could score you a tax break.

If you used the home in question as a rental or investment property (yes, they’re different), you could score a capital loss deduction. Some cases could earn you a coveted “ordinary loss” when you file. Let’s dive into what tax professionals say you need to know about navigating the tax code when deducting real estate losses.

Learn more: You locked in a low mortgage rate — now you want to move. What should you do?

The short answer is no. Capital loss tax deductions only apply to investments that have resulted in a loss, such as stocks, bonds, or real estate investments. If you sell your primary personal residence for less than you paid, there’s no capital loss to report and, therefore, no deduction on your taxes.

Why? IRS code states that personal-use property, like your home or a vacation property, isn’t an “investment.” As far as the IRS is concerned, a loss on these types of residences is just that: a personal loss (sorry).

But you may have one saving grace where you can score a tax deduction.

Investment properties and flipped homes

If you sell a property that was never used as a personal residence — like a house you bought as an investment property or with the plan to flip it — you may have losses you can claim on your taxes.

“With investment properties, losses can be deducted,” said JP Dowds, a CPA and wealth advisor with Marshall Financial, to Yahoo Finance via email. “For a flip property — not rented out — the loss is simply your cost, including improvements, minus the sale price. This is treated as a capital loss, just like selling stock, and can offset other capital gains.”

This is where the capital loss deduction comes into play. You can use a capital loss from real estate to offset capital gains from other investments. Plus, if your capital losses exceed your gains, you can deduct up to $1,500 ($3,000 if married filing jointly) of those losses per tax year against your ordinary income. Any remaining losses carry forward to future tax years until you’ve claimed the total loss.

You’ll calculate losses using Schedule D and claim the loss on line 7 of the Form 1040 applicable to your filing.

Rental properties may seem like a smart tax strategy, but they come with layers of complexity when tax time rolls around. Depreciation reduces your taxable income while you own the property (yay), but it also lowers your cost basis and could create an unexpected gain when you sell. Dowds offered an example.

Let’s say you purchased a rental home for $500,000, claimed $90,000 in depreciation while you owned it, and eventually sold it for $450,000. Even though that looks like a $50,000 loss, your adjusted cost basis is $410,000 ($500,000 minus $90,000 depreciation). So selling it at $450,000 creates a $40,000 gain.

“Big picture: Rental properties aren’t the tax haven many expect,” said Dowds. “Deductions like depreciation help in the short term, but they reduce your cost basis and often lead to a bigger tax bill when you sell.”

Remember when we mentioned complexity? Well, depreciation recapture can also come back to bite you. Since you get the tax benefits of depreciation while you own a rental, the IRS wants some of those benefits back when you sell (naturally) — that’s depreciation recapture. Any gains at sale resulting from depreciation recapture could be taxed at the lower of your ordinary income tax rate or 25% — instead of the typical capital gains rates, which range from 0% to 20%.

Second homes and vacation properties

Not all non-primary homes qualify for a loss deduction. If you occasionally used the home for vacation or personal purposes, it’s still considered a personal-use property by the IRS, even if you never lived there full-time. Thus, your losses on this property are not deductible.

On the other hand, if you owned a second home strictly for investment purposes (that is, with no personal use), the IRS wouldn’t consider this a personal-use property. Therefore, you can potentially deduct losses from the sale of the property under capital loss rules.

Conversions and Section 1231 property

Ready for more complexity? You’ve got it — especially if you’re selling a home that started as a personal residence that later became a rental. This use change can significantly impact how the IRS treats the sale and any losses derived. Lisa White, a CPA with tax advisory firm Fiondella, Milone & LaSaracina LLP, offered an example to illustrate.

Imagine you bought a condo when you were single. Later, you get married and move into a new home, then decide to rent out your condo. When you eventually sell your rental condo, it’s no longer a personal-use property. It’s now considered business-use real estate under Section 1231 of the IRS tax code.

Business-use real estate refers to property used for trade or business purposes. That includes rental homes you lease to generate income. To qualify as a business-use property, a property must be used primarily for business purposes (a consistently revenue-generating rental) at the time of sale.

Section 1231 rules state the following about capital gains and losses:

Properties sold at a gain. Gains get taxed as long-term capital gains (more favorable).
Properties sold at a loss. Losses could be classified as ordinary losses, which can offset ordinary income without being subject to the $3,000 annual capital loss cap.

There’s one important caveat, however. “The basis for that loss would be the lesser of the adjusted basis of the property or the fair market value at the time you started using it as a rental,” said White.

So, if you convert a home to a rental, don’t forget to document both values at the time of conversion so you can use the most favorable value when it's sold.

If you plan to claim any kind of real estate-related loss, you’ll need to back it up with solid documentation.

“You’ll definitely want to have a copy of your closing statement — both for the time of purchase and the time of sale,” said White. The purchase closing statement helps establish your initial cost basis, which the sale statement verifies your proceeds and transaction costs.

You should also keep additional documentation, including:

Receipts for capital improvements (e.g., roof replacement, new A/C system, home additions)
Depreciation schedules for rental properties
Appraisals or market value estimates, if you convert a home to a rental

“If the IRS does come knocking, it’s going to be up to you to prove where that [cost] basis number came from,” White said.

Rental losses get treated differently when you own the rental versus when it's sold.

“Rental losses are usually considered passive and can’t offset other income each year [when you own the rental],” said Dowds. “But they carry forward and become deductible when you sell the property. This is a helpful offset to any surprise capital gain.”

Some states follow federal tax rules on capital losses, depreciation, and passive activity, while others don’t. High-tax or non-conforming states may have different rules for real estate losses.

Working with a tax professional well-versed in your state’s tax rules can help you maximize your state’s tax rules before you sell.

You don’t have to pay capital gains tax when you sell your home at a loss because you haven’t gained any money by selling. However, you probably can’t get a tax break for selling at a loss, either. If you sell any home classified as a primary residence or personal-use property, the IRS doesn’t allow you to deduct those losses on your income taxes. The only way to potentially claim losses on the sale of a home is if the property was used as a rental or strictly as an investment property.

The $3,000 capital loss rule states that you can use up to $3,000 in capital losses to offset ordinary income per tax year. If your capital losses are greater than $3,000, you can carry forward remaining losses to future tax years, deducting up to $3,000 per tax year until you’ve claimed all losses.

You may be able to deduct losses from the sale of a rental or investment property on your taxes, provided the property meets specific IRS guidelines. For rentals, the most basic rules state that the property must be used as a rental property at the time of sale. For investment properties, you must not have used the property for personal use (such as a sometimes-vacation home) at any time during ownership. From there, it’s best to consult a tax professional regarding what kinds of losses you can deduct on your taxes at sale.

Laura Grace Tarpley edited this article.