Every Kind of Loss That Can Offset a Property Sale Gain
Gain from selling a rental wears two hats. It is passive income under §469 and, after §1231 netting, long-term capital gain on Schedule D. So two families of losses can meet it: passive losses and capital losses. A third group of deductions, including a net operating loss, lowers the income stacked underneath it. And a few pieces of a sale can't be reached by any of them.
This page is a map of how the tax law treats each kind of loss once it is on your return. It does not suggest acquiring any loss or any investment. How and whether losses are generated is a question for your investment adviser.
Two hats, one gain
- Passive hat. Gain on selling a rental, including depreciation recapture, is passive activity gross income for an owner who is not a qualifying real estate professional (Temp. Reg. §1.469-2T(c)(2)(i)(A)). Passive losses are allowed against it.
- Capital hat. A rental held more than a year is §1231 property. A net §1231 gain for the year is treated as long-term capital gain (§1231(a)). Capital losses come off it on Schedule D.
A capital loss does not use up the passive income the gain supplies, and a passive loss does not use up the capital gain. Both can meet the same sale, at different stages of the return.
The Loss Bank, a free guide, walks through these rules with worksheets for you and your CPA. Get The Loss Bank.
1. Suspended passive losses on the property you sold
Under §469(g)(1)(A), when you dispose of your entire interest in a passive activity in a fully taxable sale to an unrelated buyer, that activity's suspended losses are freed against any income, wages included.
On an installment sale, §469(g)(3) frees them year by year, in the ratio of the gain recognized that year to the total gross profit on the sale. A related-party sale holds them back (§469(g)(1)(B)). And if the building is grouped with others (Reg. §1.469-4), or you made the real estate professional aggregation election, selling one building is not a disposition of the entire activity. For the mechanics, see suspended passive losses when selling a rental and installment sales and passive losses.
2. Current-year and carried-over passive losses from other activities
Losses from your other rentals, including their depreciation, and losses on K-1s from businesses you don't materially participate in, are passive (§469(c)(1), (2)). They are allowed against passive income, and the sale gain is passive income. The gain can absorb carried-over losses from every passive activity you hold, not just the one sold.
One timing rule matters on a note: whether installment gain is passive is fixed in the year of sale (Temp. Reg. §1.469-2T(c)(2)(i)(A)), so gain from a passive rental stays passive in each later year it is recognized. Appreciated property that was nonpassive within 24 months of the contract can be treated as nonpassive (Reg. §1.469-2(c)(2)(iii)).
Exceptions: losses from a publicly traded partnership offset only income from that same partnership until you dispose of your entire interest (§469(k)). Oil and gas working interests and royalties follow their own rules; see passive losses beyond real estate.
3. Capital losses and carryforwards
A capital loss offsets capital gain dollar for dollar, then only $3,000 a year of ordinary income ($1,500 married filing separately) (§1211(b)). The rest carries forward, keeps its short-term or long-term character, and has no expiration during your life (§1212(b)).
Which layer it hits matters. A long-term carryforward, or a net short-term loss, goes to the 25% layer (unrecaptured §1250 gain) first (Notice 97-59). On an installment sale, that 25% layer comes out of the payments first (Reg. §1.453-12(a)). A long-term loss realized in the current year nets inside the 0/15/20% group first.
A capital loss carryforward can be used only on the decedent's final return and does not pass to heirs (IRS Pub. 559).
Illustrative example (The Loss Bank, Chapter 9): Married filing jointly, $300,000 of other income, a $2,000,000 gain, 2026 federal tables held constant, tax on the gain only. $500,000 of capital losses on the return over five years cut federal tax on the gain by $94,310 with a cash sale, and by $126,672 on a ten-year installment schedule, because losses that land in later years have gain to meet.
The loss your return uses against one year's installment gain is what The Loss Bank calls a scoop: one scoop a year, sized to that year's payment. Only the payment schedule is shaped, to the losses your adviser and CPA project.
4. §1231 losses, and the five-year lookback
A §1231 loss is not a capital loss. All §1231 gains and losses for the year are netted on Form 4797. If losses win, the net is an ordinary loss (§1231(a)(2)). So a §1231 loss on other business property sold the same year nets against the installment gain before Schedule D.
Then the lookback: a net §1231 gain is treated as ordinary income to the extent of net §1231 losses from the prior five years that have not already been recaptured (§1231(c)). The test runs every year installment gain is recognized. The recaptured amount comes out of the 25% layer first (Reg. §1.453-12(d), Ex. 3), and a capital loss reaches the ordinary income that results only through the $3,000 allowance. See Form 4797 instructions.
5. Net operating losses, briefly
A net operating loss carryforward does not touch the gain directly. It lowers taxable income, so less income sits under the gain and more of the gain lands in lower brackets. For losses from 2018 on, it can offset only 80% of taxable income in a year (§172(a)(2)). Business losses above the excess business loss limit ($512,000 joint for 2026) become an NOL carryforward (§461(l)); see excess business loss limitation. California allows no NOL deduction in 2024 to 2026 unless income is under $1,000,000 (R&TC §17276.24).
What no loss can fully reach
| Piece of the sale | Why | What reaches it |
|---|---|---|
| §1245 recapture (cost segregation, equipment, furniture) | Ordinary income, recognized in full in the year of sale even on a note (§453(i)) | Passive losses, yes (the recapture is passive income). Capital losses, only $3,000 a year. |
| §1231 lookback income | Recharacterized as ordinary (§1231(c)) | Capital losses, only $3,000 a year. |
| Note interest | Portfolio income (Temp. Reg. §1.469-2T(c)(3)) | Passive losses, never. Capital losses, only $3,000 a year. |
| Gain on land held for investment, not rented | Portfolio income, not passive (§469(e)(1)) | Capital losses, yes. Passive losses, no. |
A loss inside an IRA, a loss on personal-use property, and a loss disallowed as a wash sale do not reach the return in the year of sale at all.
Bottom line
Suspended passive losses on the property sold are freed by the sale, pro rata on a note. Other passive losses meet the gain because the gain is passive income. Capital losses meet it on Schedule D, 25% layer first. §1231 losses net first and can turn later gain ordinary for five years. NOLs lower the income under the gain. §1245 recapture and note interest are the pieces capital losses can reach only $3,000 at a time.
The Loss Bank, a free guide, walks through these rules with worksheets for you and your CPA. Get The Loss Bank.
Questions to ask your CPA
- How much suspended passive loss is attached to the property I am selling, and how is it grouped?
- What passive carryovers do I have from other activities?
- What are my capital loss carryforwards, short-term and long-term?
- Did I have a net §1231 loss in any of the last five years?
- How much of my gain is §1245 recapture recognized in year one?
- Do I have an NOL carryforward, federal and California?
For your CPA: §469(c)(1)-(2), (e)(1), (g)(1)(A)-(B), (g)(3), (k); Temp. Reg. §1.469-2T(c)(2)(i)(A), (c)(3); Reg. §§1.469-2(c)(2)(iii), 1.469-4; §1231(a), (c); Reg. §1.453-12(a), (d) Ex. 3; §§1211(b), 1212(b); Notice 97-59; IRS Pub. 559; §453(i); §§172(a), 461(l); R&TC §17276.24.
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Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.