It's painful enough to have to sell your personal home for a loss. To make matters worse, the Internal Revenue Service doesn't allow taxpayers to deduct a loss on the sale of a personal residence. At the same time, with few exceptions taxpayers also don't have to pay taxes on the gains from the sale of their personal homes. Taxpayers can deduct losses from the sale of investment homes and rental homes, but the tax requirements are strict and losses can be limited.
You can never deduct losses on the sale of a personal residence. On the upside, you rarely have to pay taxes on gains from the sale of a personal residence. The IRS allows single taxpayers a $250,000 exclusion -- $500,000 for married couples -- on the gain from the sale of a personal residence. Any excess above the exclusion is taxable as a capital gain. To qualify for this exclusion, the taxpayer must have lived in the home for at least two of the last five years before the sale.
If you bought a home as an investment and sold it for a loss, the loss is deductible. To qualify as an investment property, you must have purchased the home solely for investment purposes and have never used it for personal affairs. That means there's no way to convert a former personal residence into an investment property for tax purposes. If you do incur a loss on an investment property, it's deductible as a capital loss. Capital losses can be only used to offset capital gains. If you don't have capital gains, or have more losses than gains, you can deduct an extra $3,000 a year. Any excess loss is carried forward to future years until you use it up.
Taxpayers can also deduct some of the loss on the sale of a rental property. The IRS only considers a home to be a rental property if you didn't live in it for more than 14 days per year or 10 percent of the time the unit was rented out, whichever number is larger. That means if your home was rented 300 days out of the year, you can live in it for 30 days and still call it a rental property. If you only rented it out for 100 days, you can live there for 14 days and be okay, since 14 days is more than 10 days.
Limitations on Rental Home Losses
Converting a home into a rental property to get a tax deduction on the loss isn't always a good strategy. That's because the basis you must use to calculate the loss is the lesser of the home's original cost or its fair market value when it became a rental property, plus additions and improvements and less depreciation taken. For example, say you bought your home for $500,000 and converted it to a rental when it was valued at $300,000 a few years later. $300,000 is now your new basis, so selling it for $275,000 only generates a $25,000 loss.