The Internal Revenue Service treats your house as a piece of personal property, like your computer or your easy chair. Since, in its eyes, it isn't an investment, you can't deduct any losses that you incur on it, although you can use some of your expenses to adjust your purchase or sales price to reduce your taxable gain. If you have an investment property, though, the rules are completely different.
When you sell a personal residence for a profit, you have to pay capital gains taxes on the difference between what you paid for it and what you sold it for. However, the IRS looks at your adjusted basis, which is your purchase price plus your closing costs plus the cost of any improvements that you made, instead of your actual purchase price. Your sale basis is what you sold the property for after any closing costs and commissions. These adjustments for the money that you lost on closing costs and improvements can significantly reduce your capital gains liability.
When you have an investment property, you have to report your taxable income or loss to the IRS with your annual tax return. Given that you are allowed to subtract just about every expense that you incur in owning the property from your rental income, it's possible that you could end up with a loss. You can use the loss to offset income from any other investment property on which you earn a profit. If you don't have other profit to offset, you can claim up to $25,000 of losses per year against other income, as long as your Adjusted Gross Income is $100,000 or less. If your AGI is more than $100,000, you lose $1 of offset for every $2 of income. Losses that you can't use can be carried forward to future years.
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Selling an investment property at a loss also gives you valuable tax deductions. The IRS lets you use capital losses to offset other capital gains so, for example, if you lost $100,000 on your rental property, you could sell stock that had appreciated by $100,000 and not pay any taxes on that stock sale. If you have more loss from the sale of your real estate property than you have gains to realize, you can also write off up to $3,000 of your capital loss against your income. Any loss that you don't use gets carried forward to the future until you either use it to offset other gains or use it up by claiming your $3,000 loss.
Converting Personal Residences
There is a way to deduct a loss on your personal residence -- you just have to turn it into an investment property. Once you've converted your home into an investment, you will have to report your profit or loss from renting it out, but you will be able to sell it at a loss and use the loss like any other capital loss. The one drawback to this method is that the IRS will calculate your loss based on the property's adjusted basis or its value on the date you converted it to use as a rental property -- whichever is less. As such, if you wait until its value has already dropped significantly to convert it, you might not end up with much of a loss to deduct. If you're considering this option, an accountant can help you formulate a strategy which should start with getting an appraisal.