Capital Gains Tax When Selling a Rental at a Loss

No gain, no capital gains tax

Capital gains tax applies only to gains. If your adjusted basis (purchase price plus improvements, minus depreciation) exceeds your net selling price, you have a loss rather than a gain, and no capital gains or depreciation recapture tax applies. The loss may actually be valuable.

Rental property sales are Section 1231 transactions. If your net Section 1231 gains and losses for the year are negative (a net loss), the net loss is treated as an ordinary loss — deductible against any income, not just capital gains. This is one of the favorable features of real estate: losses are ordinary, but long-term gains receive capital gains rates.

Suspended passive losses are released

If you have accumulated passive activity losses from the rental that you couldn't use in prior years (because of the passive activity loss rules), the year you sell the property in a fully taxable transaction releases all suspended passive losses. You can deduct them in full in the year of sale, even if you have no other passive income — they convert to ordinary deductions.

This means selling at a small loss, or even a gain, can still be tax-favorable if it unlocks years of suspended passive losses that offset your other income.

Depreciation recapture when selling at a loss

If you sell below your original purchase price but still above your adjusted basis (which is reduced by all depreciation you claimed), there is still a taxable gain — and depreciation recapture applies to it. For example: purchased at $400,000, claimed $60,000 depreciation, basis is $340,000, sold at $360,000. The $20,000 gain is less than the $60,000 depreciation, so the entire $20,000 is recaptured as unrecaptured Section 1250 gain at up to 25%.

Section 1231 netting and the five-year lookback

Rental property is Section 1231 property, and 1231 gains and losses are netted together each year across all your business-use property. If the year’s net 1231 result is a gain, it is generally treated as long-term capital gain; if it is a loss, it is treated as an ordinary loss deductible against any kind of income. This favorable, asymmetric treatment is one of the best features of the tax code for real estate owners.

There is one catch: the five-year lookback rule of Section 1231(c). If you deducted a net 1231 loss as ordinary in any of the prior five years, a later net 1231 gain is recharacterized as ordinary income to the extent of those prior unrecaptured losses. In other words, you cannot take an ordinary loss one year and a preferential capital gain the next without the lookback clawing back the earlier benefit. Track your net 1231 losses for at least five years.

Worked example: a loss that unlocks suspended losses

Suppose you bought a rental for $300,000, claimed $50,000 of depreciation (adjusted basis $250,000), and sold it for $240,000 after $16,000 of selling costs — an amount realized of $224,000. Your loss is $224,000 − $250,000 = $26,000. Because there is no gain, there is no depreciation recapture. The $26,000 is a Section 1231 loss; if it is your only 1231 transaction that year, it is an ordinary loss deductible against wages, interest, and other income.

Now add $40,000 of suspended passive losses accumulated over the years you couldn’t deduct them. A complete, fully taxable disposition releases all of them. So in the year of sale you deduct the $26,000 ordinary 1231 loss plus $40,000 of freed passive losses — $66,000 of ordinary deductions — even though the sale itself only cost you $26,000 economically. This is why selling a chronically loss-generating rental can produce a large tax benefit in the exit year.

Personal-use property is different: losses are not deductible

The favorable loss rules apply only to property held for business or investment. A loss on the sale of a personal-use property — your home, or a vacation house you never rented — is a nondeductible personal loss. You cannot deduct it against income or use it to offset gains. This is the mirror image of the gain rules: personal residences get an exclusion on gains but no deduction on losses, while rentals get ordinary-loss treatment but fully taxable gains.

If you converted a former residence to a rental before selling, the deductible loss is limited: your basis for computing a loss is the lower of adjusted cost basis or fair market value at the date of conversion, then reduced by depreciation. This prevents you from deducting a decline in value that occurred while the home was still personal-use.

How the loss interacts with capital-loss limits and NIIT

A net 1231 loss treated as ordinary is not subject to the $3,000 annual capital-loss limitation — that limit applies to capital losses, and an ordinary 1231 loss is fully deductible in the current year with no carryforward cap. However, if in a given year your combined transactions net to a capital-loss character (for example, 1231 items combined with capital losses from stock), the ordinary carve-out may not fully apply, so run the netting carefully.

A loss year also generally means no Net Investment Income Tax on that property, since NIIT applies to net investment income. But be careful: recapture can still create positive taxable gain even in what feels like a loss sale, as covered above, and that gain can carry NIIT.

Reporting and planning

Report the sale on Form 4797. Section 1231 losses flow to Part I and then to the ordinary-loss lines of your return; suspended passive losses freed by the disposition are reported through Form 8582. Keep documentation of your adjusted basis and accumulated depreciation — the IRS uses the “allowed or allowable” standard, so your basis is reduced by depreciation you were entitled to claim even if you never actually claimed it.

From a planning standpoint, if you own one property with a built-in gain and another with a built-in loss, consider the timing: recognizing them in the same year lets the 1231 loss offset the 1231 gain, but watch the five-year lookback so you don’t inadvertently convert a future gain to ordinary income. When the character and timing are unclear, have a CPA model the netting before you sign a sale contract.

Foreclosure, deed-in-lieu, and abandonment losses

A loss does not only arise from a voluntary sale. A foreclosure or a deed in lieu of foreclosure is treated as a sale of the property for tax purposes. For nonrecourse debt, the amount realized generally equals the outstanding balance of the loan; for recourse debt, the amount realized is the property’s fair market value, and any debt forgiven above that value is treated separately as cancellation-of-debt income. The resulting gain or loss on the property itself follows the Section 1231 rules described above.

Cancellation of debt (COD) income can complicate a loss. If a recourse loan is forgiven, the forgiven amount is generally ordinary income unless an exclusion applies — insolvency, bankruptcy, or qualified real property business indebtedness under Section 108. It is entirely possible to have a deductible Section 1231 loss on the property and taxable COD income in the same transaction, because the two are computed separately.

Abandonment of worthless property can also generate an ordinary loss, but only if you truly relinquish all rights and receive nothing in return; if debt is discharged as part of the abandonment, sale treatment usually applies instead. One more point on unused losses: even when a loss is deductible in character, the passive activity and at-risk rules can defer when you get to use it. Suspended passive losses are freed in full on a complete taxable disposition, but the at-risk limits of Section 465 can independently cap a loss to the amount you actually have economically at stake. Check both hurdles before assuming a loss is currently deductible.

Frequently asked questions

Do I owe tax if I sell a rental at a loss?

No capital gains tax is owed if you have a true loss. If the sale price is below your adjusted basis, the net Section 1231 loss may be deductible as ordinary income.

What happens to passive losses when I sell a rental at a loss?

All suspended passive losses are released in the year of a complete, taxable disposition. They become ordinary deductions available against any income in that year.

Can I still owe depreciation recapture if I sell below purchase price?

Yes — if the sale price exceeds your adjusted basis (which was reduced by depreciation), there is gain equal to that difference, all of which is recapture.

Can I deduct a loss on a rental property?

Yes. A loss on a rental (Section 1231 property held for business) is generally an ordinary loss deductible against any income if your net 1231 result for the year is a loss — more favorable than a capital loss.

Are losses on a second home or vacation home deductible?

Generally no. A loss on personal-use property, including a vacation home you did not rent out as a business, is a nondeductible personal loss.

What is the five-year lookback on 1231 losses?

If you claimed a net Section 1231 ordinary loss in any of the prior five years, a later net 1231 gain is recharacterized as ordinary income to the extent of those unrecaptured prior losses.

Is a foreclosure or deed-in-lieu treated as a sale?

Yes. For tax purposes a foreclosure or deed in lieu of foreclosure is a disposition of the property, with the amount realized based on the debt (nonrecourse) or the property's fair market value (recourse). Any recourse debt forgiven above fair market value is handled separately as cancellation-of-debt income, which may be ordinary income unless an exclusion under Section 108 applies.

Sources

Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.