Rental property is considered a business asset, and a sale of the property will result in a gain or loss. Tax is due only on any gain, and you can write off a loss on rental property to offset taxable income. The key factor is correctly calculating the amount of gain or loss on the property.
Profit is calculated on the sale price minus adjusted basis, not the amount you originally paid for the property. Adjusted basis is the original purchase price, minus the cost of any improvements to the property, plus the accrued depreciation on the property. Improvements include additions, construction, painting, new floors, landscaping or anything that increases the value of the property; it does not cover repairs or maintenance, which should have been deducted as expenses in the year incurred.
Each year, the IRS allows a deduction against rental income for depreciation on the property. When you sell the property, in essence, you are paying back that deduction. If for any reason you failed to take the depreciation deduction in prior years, you still must add the accrued amount when calculating adjusted basis, increasing your gain or reducing your loss. You may file an amended return to correct the unclaimed depreciation in a prior year, for up to the last three tax years.
If you occupied a portion of the rental property, such as one unit in a duplex or multi-unit building, you must treat the sale of each portion as separate properties, prorating the amount of gain or loss by the percentage allocated to business and personal use. You may not take a capital loss on the personal portion of a property, but you may be entitled to a tax exclusion on the portion of capital gains on residential-use units.
Type of Gain
Gains and losses are classified as ordinary or capital gains. Gains on business assets such as rental property are generally considered ordinary gains, particularly when the property was purchased to produce a rental income stream. Gains on property bought and sold primarily to profit on price appreciation are classified as capital gains. The IRS separates the gain from depreciation (ordinary gain) from the gain on price appreciation (capital gain), resulting in the possibility of both types of gains on the sale of rental property. In the case of a loss, all losses are considered ordinary losses and can offset ordinary income up to $3,000 in a tax year.
The bad news if you have a gain is that the depreciation (ordinary) portion of the gain is taxed at a higher rate than the price appreciation because you received a deduction against income each year for the amount of depreciation, thus saving taxes equal to the depreciation times the income rate. In 2012, the capital gain is taxed at 10 or 15 percent for long-term gains (property held one year or more), depending on your tax bracket. Short-term capital gains on property held for less than one year and the depreciation portion of long-term gains are taxed as ordinary income, based on your tax bracket.
Naomi Smith has been writing full-time since 2009, following a career in finance. Her fiction has been published by Loose Id and Dreamspinner Press, among others. She holds a Master of Science in financial economics from the London School of Economics and a Bachelor of Arts in political economy from the University of California, Berkeley.