How tax-loss carryforward works with rental properties
If you're not able to deduct your rental losses, the IRS allows you to carry the losses forward into future tax years to deduct against future rental profits. These losses can be carried forward indefinitely.
For a tax-loss carryforward, you'll have to keep detailed records of how the losses were carried forward, how much of the loss was used in each tax year, and any additional losses.
When the loss is deducted in the following year, the negative amount will be listed as "other income" on your income taxes, and you must attach the statement with a record of your carryforward loss.
If you don't use all of your loss in the next year, you can continue to carry it forward until it's gone.
This year you have a tax loss of $25,000 that you carry forward to next year.
Next year, you show a net profit of $10,000.
The $25,000 loss wipes out the $10,000 profit, and you still have another $15,000 in loss to carry over to the next year.
A capital loss normally occurs when you sell a property for less than its current tax basis. This doesn't necessarily mean it's sold for less than what you paid for it.
If you paid $1 million for a property and depreciated $100,000 of it over four years, your basis would be $900,000. To have a capital loss, you'll have to sell the property for under $900,000.
Section 1231 loss
Since real estate is a Section 1231 property, any capital losses in excess of capital gains can be deducted from normal income. This is unique compared to assets such as stocks, which only allow you to deduct up to $3,000 toward ordinary income each year.
Writing capital losses off against ordinary income is a huge benefit because it's at a higher tax rate than capital gains tax.
For example, suppose you sell two properties this year, one at a gain of $10,000 and the other at a loss of $30,000. Before that capital loss can be deducted from any ordinary income, it first has to offset the capital gain.
The $30,000 loss wipes out the $10,000 capital gain and leaves you another $20,000 to write off against your ordinary income.
If your ordinary income for the year is $80,000, you can deduct the remaining $20,000 from your ordinary income on your tax returns.
If your Section 1231 loss was large enough to offset any capital gains and reduce your ordinary income to zero, you can carry forward any remaining loss.
For example, let's say you have a capital loss of $100,000 with no capital gains, and your ordinary income is $80,000. The loss of $100,000 will reduce your income to zero and leave you with another $20,000 to carry forward to the following year.
If you have a capital gain the following year, the loss will first have to be applied to it. If there is still a loss remaining, or you don't have any capital gains that year, the remaining $20,000 capital-loss carryforward can be used to reduce your ordinary taxable income again.
The bottom line
While losses never sound like a good thing, they can come in handy later to lighten your future tax burden. Besides, with real estate, a tax loss doesn't necessarily mean you didn't make money.
Understanding how taxes work in real estate can help you make decisions throughout the year that will be most beneficial when it's time to file your taxes. The IRS offers a lot of tax advantages to real estate investors, and a tax-loss carryforward is one that can be a silver lining on a deal gone bad.