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In a stagnant real estate market, many homeowners are facing the prospect of selling their homes for a loss. Although normally a loss taken on the sale of personal property, including a house, is not tax-deductible, you can take a write-off in certain limited circumstances.
When you sell your home for your profit, the IRS assesses capital gains taxes, although a generous amount of gain is excluded. For example, a married couple filing jointly can exclude up to $500,000. On the flip side, however, any loss you take on the sale of a personal residence is not deductible under any circumstances.
In principle, the IRS allows deductions only for losses on the sale of investment property, and moreover, it limits that deduction to $3,000 a year, although you may carry higher losses forward to the next tax year. A primary residence is not considered an investment. Instead, the IRS classifies it as personal property, in the same category as a car, jewelry, antiques, artwork or furniture. You can't write off a loss on the sale of any of these items.
You may deduct the loss on the sale of a house if you've converted it to investment property. That means making it a rental, for which you collect rent from a tenant and pay non-homestead property taxes. The IRS will not allow the deduction if you've simply offered the home for rent, or if you still live in it. By a general rule known as "two-year-old and cold," property you're renting out for at least two years is considered investment property.
The IRS will allow a full deduction for a loss on the market-value basis at the time you converted it -- not on your original purchase price. You then add the cost of any improvements and subtract depreciation from that basis. In order to determine the basis, you should have an appraisal done at the time of the conversion. To claim a loss deduction for investment or rental property, you must file Form 4797, Sale of Business Property, with your tax return. The proceeds of the sale should be reported to you on Form 1099-S.
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