This article is an excerpt from Amanda Han’s The Book on Tax Strategies for the Savvy Real Estate Investor. Pick up a copy from the BiggerPockets bookstore to learn how you could be saving more on your taxes!
“When you lose money in real estate, call on Uncle Sam to help you shoulder the burden.” —Anonymous
As wonderful as real estate investing can be for wealth building, we have yet to meet a real estate investor who has never lost money. In fact, the two of us have made some not-so-good investment decisions in the past ourselves and have lost our share of money in real estate deals gone sideways.
The silver lining is that we can hopefully take what we’ve learned and come out the other side as better and more astute investors. What investors forget about are the potential tax benefits available when they lose money on deals.
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Real Life Example
Connie has always been an ambitious woman. After working as an executive in corporate America for over two decades, she stood shoulder to shoulder with some of the most successful men in the world. Connie did not like mistakes and took extra steps to make sure she didn’t make them often. So when she started investing in real estate six years ago, she did so only after careful analysis of both the market and her two target properties.
It’s hard, if not impossible, to predict the future, however. We have a” had moments when we thought, “If I had only known then what I know now.” Let’s just say this was Connie’s first experience with real estate.
Six years ago, Connie announced to her husband that they were going to invest in real estate. Through her research, she had determined that downtown Las Vegas was going to be a great area to invest in. Everything she had read indicated that the Las Vegas market had been exploding with growth over the past several years. With the proposal of a downtown revitalization program, prices in the area were sure to skyrocket in the coming years. The two properties Connie had under contract were not in the best of neighborhoods, but with the expected revitalization program, Connie felt her money would be safe invested in the two rentals. After all, what could go wrong with rental real estate, right?
Actually, it looked like a lot of things could go wrong.
Connie was trying to decide whether or not to hire a management company for her properties. She liked the idea of not having to deal with tenants but cringed at the thought of handing over 8% of her rent in management fees each month. She thought she would test the waters by first listing the properties on Craigslist to see if she could fill the houses herself, and things started out great. Both rentals were snatched up by tenants almost as soon as she listed them online; however, she didn’t get very far before her luck ran out.
The tenants who moved into the first rental property never paid rent beyond the initial deposit and first month. From that point on, Connie spent a lot of time and effort each month trying to coax these people into paying her. What she later learned was that these terrible tenants were actually professional scammers.
They knew the system and were able to work it to their advantage to stay in a place as long as possible without paying. Not until after almost eight months of zero rental income did the courts finally force eviction on these tenants. To make matters worse, when the scammers finally left, they trashed the house and took whatever fixtures and appliances they could with them. Connie was shocked to find out that they even took the doorknobs off all the doors before smashing in the windows and leaving.
Connie’s second rental didn’t work out much better. Although this tenant paid on time, she was a major headache and would call Connie on a weekly basis with complaints about things that needed to be fixed. From leaky plumbing to broken a dishwasher, it seemed to Connie that the repairs list for this unit was constantly growing. After a few months of management, Connie finally threw in the towel and hired a management company. By then, she was more than happy to pay the 8% management fee. In fact, she was happy just to get her life back; it was not easy to work a full-time job and manage her rentals.
Unfortunately for Connie, her stream of bad luck didn’t end there. Over the next several years, the real estate bubble burst, and Las Vegas was one of the hardest hit areas. The drop in home prices led to a drop in rents as well. With the downturn in the economy, the big downtown revitalization project was put on hold indefinitely. Connie’s real estate dream had turned into a real estate nightmare. With two rentals that had negative cash flow and negative equity, she gave the properties back to the bank and walked away from her failed investment.
This was not an easy decision for Connie, and she lost quite a bit of money on the deal. Over the years, she had accumulated roughly $40,000 in losses on her tax returns that were considered passive losses. Her CPA explained to her that these losses were being preserved for future use, because her income was too high for the losses to help her at the time. The good thing, her CPA noted, was that she could use the losses to offset any future gains she would get on the sale of the rentals. As it turned out, future gains were the last thing on Connie’s mind. She just wanted to get out with as little loss as possible.
Connie initially purchased the properties for a total of $435,000. With outstanding loans of $320,000 and the current market value of her rentals at only $220,000, Connie’s only options had been a short sale or foreclosure.
With the help of a friend in the mortgage industry, she was able to negotiate a short sale with the bank on both properties. Connie was extremely pleased to have ended her real estate nightmare with as few bruises as possible—or so she thought until she met with her CPA.
Adding Insult to Injury
Connie had heard from friends about people who had gone through short sale transactions and needed to pay taxes. She just never thought she would be one of them. When Connie met with her CPA the following April, she was disappointed to learn that the 1099 the bank issued her for $320,000 was indeed something she needed to pay taxes on. Her CPA explained that because the bank had relieved her of this debt, it was as if the money had been given to her, and as a result, this was technically income she owed taxes on.
The CPA said that silver lining in all this was that Connie had accumulated losses on the rentals over the previous several years, and those losses would help reduce her taxes in the future. The only caveat was that the losses were capital losses.
Capital losses are not like ordinary losses that you can use to offset your income without limitations. On the contrary, capital losses can only offset capital gains, and if there are excess losses, you can take only $3,000 each year on your tax return. The rest needs to be carried forward into future years.
Therefore, Connie ended up with a large tax bill thanks to the bank’s 1099 as well as a significant amount of capital losses she could offset with only $3,000 on her tax return. Although she was glad the rest of the losses would roll forward and not be disallowed or disappear, she wished she were able to use them right away to offset the 1099 income.
To Connie, this felt like adding insult to injury. It was bad enough that she had lost so much money on her real estate deals, but it seemed like the IRS was kicking her on her way down. Something didn’t seem right.
Connie called up her friend Clarice, who had recently gone through a similar ordeal. After hearing that Clarice’s CPA had been able to help her avoid taxes, Connie decided to get a second opinion on her own situation.
Speaking with Connie for the first time was almost exactly like the first time we spoke with her friend Clarice. In fact, their situations were almost identical. Even though they were working with two different tax advisors, those advisors had made the same unfortunate mistake—one we see very often with real estate losses.
Getting a 1099 Doesn’t Always Mean You Need to Pay Taxes
The big mistake Connie’s tax preparer had made involved the short sale transaction. He was correct in stating that Connie may have had to pay taxes on the 1099 income from the bank. However, it isn’t just a straightforward matter of entering that amount on the tax forms and letting the software decide the tax.
In fact, if dealt with correctly, that income could have actually worked to Connie’s advantage. How can you go from taxable income of $320,000 to a tax advantage, you ask? Let’s break down Connie’s situation one step at a time to see how her tax return should have been done.
Cancellation of Debt Income
$320,000 Debt Outstanding
($220,000) Fair Market Value
$100,000 Cancellation of Debt Income
The first step was to calculate how much of the $320,000 of discharged debt was actually taxable for Connie. The 1099 from the bank was inaccurate in showing that the entire outstanding debt amount was taxable. Although the outstanding loan balances totaled $320,000 just before the short sale, the entire amount was not taxable for Connie. The fair market value of the properties—which they actually sold for—can be used to reduce the taxable income. So in Connie’s case, only $100,000 of the $320,000 of 1099 income was taxable (i.e., only $100,000 of the loan balances were “forgiven”).
This was very important to show on Connie’s tax return, because it immediately moved $220,000 from the taxable bucket into the tax-free bucket.
Don’t Forget Your Losses
The next step is to look at what losses, if any, Connie incurred as a result of this transaction. To determine this, we looked at the difference between what the properties sold for (i.e., their fair market value) and Connie’s cost basis in the properties. To keep things simple for illustration purposes here, we will assume Connie took no depreciation on the two rentals, so her basis was the properties’ initial purchase price: $435,000.
$220,000 Sales Price
($435,000) Cost Basis
($215,000) Ordinary Loss
As you can see, Connie had a loss of $215,000, according to this calculation. But here is where the capital loss mistake commonly occurs. Connie’s tax preparer, like quite a few others we’ve seen, treated this $215,000 as a capital loss instead of an ordinary loss. As a result, Connie was not able to use the loss to offset her cancellation of debt income.
The truth is that losses on rental properties are ordinary losses, not capital losses. Because the loss on the sale of rental properties is an ordinary loss, there is no limit to how much can be used each year to offset taxes. In Connie’s example, she was legitimately able to use her loss on the sale of the properties to offset the cancellation of debt income.
$100,000 Cancellation of Debt Income
($215,000) Ordinary Loss
($115,000) Net Ordinary Loss
Connie was able to use all her real estate losses in one year and completely wipe out the 1099 income from the bank on the short sale transactions. In addition, remember the $40,000 in losses she had accumulated over the years on her rentals? Well, that was also considered an ordinary loss she could use in the same year the properties were short sold. All in all, Connie ended up with $155,000 of additional losses after wiping out her 1099 income.
$100,000 Cancellation of Debt Income
($215,000) Ordinary Loss
($40,000) Passive Loss from Prior Year
($155,000) Net Ordinary Loss
Coming Out Ahead
The good news was that she would be able to use the ordinary losses to offset her W-2 income. At her federal and state tax rate of 38%, this meant she would receive a tax refund of $58,900. So rather than paying taxes of $121,600 ($320,000 x 38%), she was getting a $58,900 refund. That is $173,660 in tax savings!
Why is This Mistake Made So Often?
So why exactly did her tax preparer file the original return incorrectly? This is actually a fairly common mistake and an easy one to make. Tax preparers may mistakenly show the loss on the sale of a rental property as capital loss because under IRS rules, a gain on the sale of a rental property is considered capital gain. So, if you bought a property for $100,000 and sold it a few years later for $150,000, the $50,000 difference is considered a capital gain and is therefore subject to lower capital gains taxes. This is actually a tax benefit available to real estate investors. However, because the gain on the sale of a rental property is a capital gain, some tax preparers may incorrectly treat a loss in this situation as a capital loss. If you think about it, it makes sense: when you sell a rental for a gain, it is a capital gain, and if you sell it for a loss, it is a capital loss, right?
Well, if you answered yes, you would have made the same mistake Connie’s tax preparer made. The beauty of the tax world is in the loopholes. The truth is that when you sell a property for a gain, it is indeed a capital gain, and you may be able to pay less tax using the lower tax rates. However, when you sell a rental property at a loss, the loss is actually considered an ordinary loss. An ordinary loss is better than a capital loss for two reasons:
- With an ordinary loss, there is no annual limit on how much can be used to offset your income.
- You can use an ordinary loss to offset your ordinary income, which is generally taxed at a higher rate.
So yes, under IRS rules, real estate investors can actually get the best of both worlds:
- If you sell a long-term rental for a gain, you pay less taxes at the long-term capital gains tax rates.
- Conversely, if you sell a long-term rental at a loss, you get to pay fewer taxes because the losses are considered ordinary.
If you are confused, don’t worry. This strange benefit confuses most people, including tax preparers. Every year, we see a handful of investors fall victim to this common yet costly mistake. It’s important to note that this treatment is not just for short sales or foreclosures. The capital gain and ordinary loss treatment on rental properties applies to all rental transactions. So if you bought a property and sold it for a loss, you are probably looking at a big write-off on your taxes in the year you sold the property.
If you sold rentals at a loss within the last few years and now suspect those losses were not written off correctly, it doesn’t hurt to get a second opinion. What’s the worst that can happen?
As for Connie, believe it or not, she didn’t give up on real estate. She was determined to learn from her mistakes and do better the next time. In fact, with the current depressed real estate market, she was already doing research for her next deal. This was all a secret to her husband, though. Even though she was ready to make her next move in real estate, she felt her husband might need a little more recovery time.
Connie’s plan was to surprise her husband with the big $58,900 tax refund check and maybe announce her new investment plans that same day. Ha, ha!
What Does This All Mean?
Yes, it seems strange that on the sale of a rental property, you can get capital gains at a lower tax rate and higher deductions when you lose money at ordinary income rates. As investors, do we really care why this loophole exists? No, of course not! All we care is that we can use the loophole to our advantage. Losing money in real estate is painful enough; make sure to lessen that pain by capturing and maximizing all the tax benefits that go along with it.
Remember, don’t fall into the common mistake of assuming the 1099s issued by a bank are correct.
We all know that banks, like everyone else, can make mistakes. If you are ever unsure whether your taxes are being done correctly, take the time to get a second opinion!
Have you used this loophole to help reduce your real estate losses?