How Are Capital Losses Deducted?

How are capital losses deducted? This reader wants to know how to go about claiming long-term capital losses on income taxes.

Q: My wife and I sold two adjacent properties via quit claim deeds this year. We originally bought the properties in 1994 for $20,000, ($10,000 each) as an investment. We thought we’d build rentals on the land, but this never happened, and we sold the vacant lots for $7,000, ($3,500 each).

The properties were free and clear with no liens, etc. We have our primary home in a different location. We have no 1099 forms or real estate transaction forms, just the quit claim deeds with the sale amounts listed. For income tax purposes, will this be a simple long-term capital loss of $13,000 that we can carry forward until it is used up?

How Are Capital Losses Deducted?

A: The first thing you should know is that the type of deed is irrelevant when it comes to filing federal income tax forms. The only issues for you are (1) what you paid for the properties (and what costs you had in the purchase), and (2) the price you got for the properties when you sold them (along with the costs relating to the sale).

For simplicity sake, we’ll assume you had no additional costs to buy or sell the land, in that you didn’t take out a mortgage and pay fees, and didn’t pay an agent when you sold.

You’d think it was pretty simple. You paid $20,000 for the properties and sold them for $7,000, so you had a $13,000 loss. For the most part, this information may be all that you need to know to file your federal tax returns.

But when it comes to real estate, there are other factors that may come into play. If you purchased these lots for investment purposes, you may be able to claim the loss of $13,000 on your federal income tax returns. On the other hand, if you simply purchased the lots to someday put your home or second home there, you would not have purchased the lots for investment purposes, and would likely not be able to take any loss on your federal income tax returns.

Claiming Capital Losses on Investment Properties

If we suppose you did buy them as investment properties, and also assume that you get to take a loss on your federal income tax returns. Now the question is: Will the IRS consider you to be a “real estate professional?”

The IRS considers people that actively work in the real estate industry and invest in real estate as “real estate professionals.” (For more details about how the IRS defines a real estate professional, you can go to the IRS website and read Publication 925.)

Real estate professionals can take an investment property loss against their other income on their tax return. For example, if you’re considered to be a real estate professional by the IRS, you could simply complete your federal income tax return and you’d benefit by reducing your income by the $13,000 loss.

If you’re not considered to be a real estate professional, the IRS may consider your investment in these lots as a “passive” investment, which means you’ll likely be limited in how quickly you can take this loss.

You may be able to take it all at once, depending on your other income and whether you have other gains that generate passive gains. But in some cases, you might be limited on the amount of losses you can take in a particular year and you’d carry over the balance of the losses to future years. A further complication: in future years you might get the benefit of these losses if you can offset the losses against other passive income.

Do You Have Any Other Investments?

To summarize, if you’re not a real estate professional, and your income comes solely from your job and you don’t have other investments, it’s likely that the loss you have on these lots won’t do you much good. If you do have investments in stocks and receive capital gains from those stocks, you may be able to offset the loss from the lots against those gains this year and in future years.

Again, it’s hard to give a simple answer when it comes to federal income taxes. Our federal income tax system is complicated and the rules and regulations regarding passive and active investment rules are complex. For a more individualized read on the situation, please talk to your tax professional.