Tax Treatment of Home Losses on a Personal Residence

If You Sell Your Home for a Loss, Is It Tax Deductible?

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Most people will tell you that you can't write off home losses on a personal residence sale, but that's not entirely the case. As with many tax issues, there are loopholes.

The Internal Revenue Code generally prohibits any deduction for a loss on the sale of a principal residence, but it allows a deduction for a loss from the sale of a personal residence that has been converted to rental property. It limits the amount of the write-off, however, and there's no deduction for any drop in value before you begin to rent.

The Starting Point

The starting point is either the property's adjusted basis at the time of conversion or its fair market value at the time of conversion, whichever is less.

Now increase this amount to reflect rental period capital improvements that boost the property's value. Subtract rental period deductions for depreciation. You'll arrive at the property's adjusted basis at the time of sale.

The cap on your loss deduction is the amount by which the at-the-time-of-sale basis exceeds the sales price when you sell.

Adjusted Basis vs. Original Cost

The property's adjusted basis at the time of sale could be substantially less than its original cost in a sour real estate market. As a general rule, the basis starts out as the original cost including any debt assumed, such as a first or second mortgage, plus adjustments up or down.

Adjust upward to reflect outlays for certain settlement or closing costs connected with the purchase, such as legal fees or improvements.

Adjust downward for the amount of gain from a sale of a previously owned home on which tax was postponed if the sale was made before May 7, 1997. All these adjustments of your original cost result in your adjusted basis.

An Example

You buy your first personal residence for $200,000 in 2015. You move out of the house and rent it in 2019. You determine at that time that its fair market value is $180,000. You take a depreciation deduction of $20,000, and you sell the property for $150,000.

You might think that your loss is $50,000—the difference between the original cost of $200,000 and the sales price of $150,000, but the IRS limits your loss to just $10,000—the amount by which the $160,000 at-the-time-of-sale adjusted basis exceeds the $150,000 sales price.

The $160,000 figure is determined by the fair market value of $180,000 at time of conversion less the rental period depreciation of $20,000.

Possible Exceptions to the Rule

The IRS might contend that a loss should be disallowed when the rental period is for less than one year. The IRS can take the position that the seller's conversion of the residence to rental property was only temporary, not permanent.

IRS guidelines for home sellers warn that:

"You have not changed your home to rental property if you temporarily rent out your old home before selling it."

The guidelines on what's temporary and what's permanent are by no means the final word, however. They merely reflect the official IRS position on an issue and are not binding on the courts.

Nor will the IRS consider a personal residence to have been converted to rental property if:

"You place your home with a real estate agent for rent or sale and it is not rented."

Translation: You have to actually rent the home out before you can take a loss deduction. This limitation has been upheld by the courts.

The Bottom Line

Always check with a tax professional before claiming home losses on a personal residence. IRS tax laws can change every year.

Julian Block is a tax expert from Larchmont, New York.

At the time of writing, Elizabeth Weintraub, CalBRE #00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.