Dear Tax Talk,
We purchased a vacation home in December 2005 with the intention of holding onto it for five years. Well, we purchased at the wrong time and now we need to get out. The home was turned into a rental in January 2007. The rent is $900 a month and payment with taxes and insurance is $1,700. We will sell at a significant loss, and I wonder how the carryover losses will affect our taxes.
Our AGI (adjusted gross income) is more than $150,000. We purchased the home for $305,000, and the likely sale price is $200,000. We have used Schedule E and carried over all tax losses and depreciation since 2007.
If we sell this year, what will happen with taxes? It appears to me that the loss will be more than $100,000. Will we get a huge refund in 2011? Can we change our withholdings this year once property is sold in order to recoup some of the losses? This is very confusing and before we try to sell we need some help.
You made the right decision converting the vacation home to rental use prior to the collapse of the real estate market. When you convert a personal use asset such as a vacation home to business property such as a rental property, your basis for calculating future loss becomes the lower of the property's value or cost. Since the trend downward in prices started in late 2007, it is safe to assume that your business basis in the property should be your cost.
Your expected loss of $105,000 (reduced by depreciation, which is carried over in your suspended losses) on the sale will be treated as an ordinary loss in the year that you sell the property. Carryover losses also will be allowed as a deduction upon the sale as ordinary loss.
Generally, rental real estate losses are not deductible in the current year when your AGI with certain modification exceeds $150,000. Instead, these losses are suspended and carried over until you sell the property, your adjusted gross income goes below $150,000 or you have other income from real estate rental property.
Don't count your chickens before they are hatched. As you suggested, you should wait until you sell the property before you change your paycheck withholding to take into account the large loss. Whatever amount you don't get back through reduced withholding, you'll get back in a refund. Unfortunately, however, you'll probably turn around and give the money to the bank to pay off the loss on the property.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Taxpayers should seek professional advice based on their particular circumstances.
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