Tax Loss Harvesting to Offset a Real Estate Gain: The Rules
Tax loss harvesting means selling investments that are worth less than you paid, so the realized capital loss can offset capital gains. For a property seller, the rule that matters is simple: capital losses offset real estate capital gain dollar for dollar, including the 25% unrecaptured §1250 layer, but only $3,000 a year of ordinary income such as §1245 recapture (IRC §§1211(b), 1212(b)).
Timing is the rest of the story. A loss offsets gains in the year it is realized and then carries forward. So the question for a seller is not only "how much loss do I have?" but "will there be gain in the years my losses show up?" That is where an installment sale under IRC §453 changes the math.
What does tax loss harvesting actually do?
It turns a paper loss in a taxable brokerage account into a realized capital loss on your return. On Schedule D, realized losses are netted in a fixed order:
- Short-term losses net against short-term gains; long-term losses net against long-term gains.
- A net loss on one side offsets a net gain on the other side.
- If the total is still a loss, up to $3,000 ($1,500 married filing separately) offsets ordinary income (§1211(b)).
- The rest carries forward to next year, keeping its short-term or long-term character, with no expiration date while you are alive (§1212(b)(1)).
Harvesting does not make a loss bigger. It decides when the loss is realized, which decides which gain it meets.
Can capital losses offset a gain on selling rental property?
Yes. Gain on the sale of a rental building held more than a year is §1231 gain, and when your net §1231 result for the year is a gain it is treated as long-term capital gain. Capital losses offset it whatever its passive status: §1211(b) looks only at "sales or exchanges of capital assets," not at whether the activity was passive under §469.
Three limits apply:
- §1245 recapture is ordinary income. Depreciation on personal property, including what a cost segregation study carved out, is recaptured as ordinary income, and capital losses offset only $3,000 of it a year. On an installment sale that recapture is also taxed in the year of sale, whatever you collect (§453(i)).
- Unrecaptured §1250 gain can be offset. The depreciation you took on the building itself is taxed at up to 25%, and it is still capital gain. Net short-term losses and long-term carryovers reduce the 28% and 25% layers before the 15%/20% layer (§1(h)(4)(B), (h)(6)(A)). A current-year long-term loss nets inside the long-term group first, so it tends to hit the 15%/20% layer.
- The §1231 five-year lookback. If you deducted net §1231 losses in any of the prior five years, an equal amount of this year's net §1231 gain is recharacterized as ordinary income (§1231(c)), which capital losses can only reach $3,000 at a time.
| Piece of the gain | Top federal rate | Can capital losses offset it? |
|---|---|---|
| §1245 recapture (personal property, cost seg) | 37% ordinary | Only $3,000 a year |
| Unrecaptured §1250 gain (building depreciation) | 25% | Yes, dollar for dollar |
| Remaining long-term gain | 20% | Yes, dollar for dollar |
| §1231 gain recaptured by the 5-year lookback | 37% ordinary | Only $3,000 a year |
| 3.8% NIIT on net gain | 3.8% | Reduces the base, not below zero |
What are the tax loss harvesting rules that can kill a loss?
The wash sale rule (§1091). A loss is disallowed if, within 30 days before or after the sale, you acquire or contract to acquire "substantially identical stock or securities." The statute does not define substantially identical; that is a facts question for your adviser and CPA. Normally the disallowed loss is added to the basis of the replacement shares, so it is deferred, not destroyed.
Your IRA counts, and there the loss is gone. Under Rev. Rul. 2008-5, buying substantially identical stock inside your IRA or Roth IRA within the window disallows the loss, and the IRA's basis is not increased. The loss is permanently lost. Pub. 550 adds purchases by your spouse or by a corporation you control.
The year of the trade. For stock and securities, the loss belongs to the year of the trade date. A loss realized in January of year 2 does nothing for gain recognized in December of year 1.
Why does an installment sale make harvested losses more useful?
Because an installment sale spreads the gain. Under §453, each principal payment is part tax-free basis and part gain, at the gross profit percentage, and the gain is taxed in the year the payment arrives. Reg. §1.453-12 puts the unrecaptured §1250 gain in the earliest payments, so the 25% layer shows up first.
With a cash sale, all of the gain lands in year one. Losses you already hold (carryovers) meet it. Losses you harvest in years two through six have nothing to meet except $3,000 of ordinary income a year, unless you have other gains.
With an installment sale, gain is recognized in each payment year. Losses harvested in each of those years meet that year's gain. Your portfolio's losses and your property's gain are finally on the same calendar.
Worked example: a cash sale vs a six-year installment sale
A simple, illustrative example. Numbers are rounded and ignore state tax.
- Rental sold for a $600,000 capital gain, of which $120,000 is unrecaptured §1250 gain. No §1245 recapture.
- The seller has a $150,000 long-term capital loss carryover.
- The seller's adviser realizes about $40,000 of long-term losses in each of years two through six ($200,000 total). No wash sales.
- Installment version: six equal payments of gain, $100,000 a year.
| Cash sale | Installment sale (6 years) | |
|---|---|---|
| Gain recognized in year 1 | $600,000 | $100,000 (all §1250 layer) |
| Carryover used in year 1 | $150,000 | $100,000 |
| Year 1 taxable gain | $450,000 | $0 |
| Year 2 | Harvested $40,000: $3,000 against ordinary income, $37,000 carries forward | $100,000 gain less $50,000 carryover and $40,000 harvested = $10,000 taxable |
| Years 3 to 6 (each) | Same: $3,000 used, the rest carries | $100,000 gain less $40,000 harvested = $60,000 taxable |
| Total gain taxed | $450,000 | $10,000 + 4 x $60,000 = $250,000 |
| Losses still unused after year 6 | $200,000 - $15,000 = $185,000 | $0 |
Check the installment column: $600,000 of gain less $150,000 of carryover and $200,000 of harvested losses is $250,000. Same losses, same property. The installment version put $200,000 more of the losses against this gain, because the gain was still arriving when the losses were realized. At a 15% federal rate plus the 3.8% NIIT, $200,000 of sheltered gain is about $37,600 (simple example; your brackets decide the real figure). The cash seller keeps a $185,000 carryover, which is only worth something if other capital gains come along.
Does harvesting get around the 3.8% NIIT?
No. At high income the net investment income tax (§1411) applies to net gain, and it stays. What losses do is shrink the base: under Reg. §1.1411-4(d)(2), gain is reduced by deductible losses, but not below zero. So each dollar of gain a loss offsets also avoids 3.8%, but a large sale above the NIIT threshold still pays NIIT on the gain that is left.
Where does this fit with suspended passive losses?
They are two different banks. Suspended passive losses under §469 are released by passive income and by a fully taxable disposition of the whole activity, and they are what The Waterfall Strategy is about. Capital losses are released by capital gains of any kind. A seller who has both can let the installment gain meet both, year by year. See Form 8582 worksheet for the passive side, and The Loss Bank for a free guide on the capital side.
To see how a carryover meets gain that arrives over several years, run the capital loss carryover calculator. To model the sale itself, the installment sale calculator compares a cash sale, seller financing and a structured installment sale.
Bottom line
Harvested losses are worth the most when there is gain to meet in the year they are realized. A cash sale gives your losses one year to work. An installment sale gives them every payment year. Keep the wash sale rule, including IRA purchases, in front of every harvest, and remember that §1245 recapture and the 3.8% NIIT are mostly outside the reach of capital losses.
Questions to ask your CPA
- What is my capital loss carryover, short-term and long-term, from last year's Schedule D?
- How much of my sale is §1245 recapture, unrecaptured §1250 gain, and other capital gain?
- Did I deduct any net §1231 losses in the last five years?
- In which layer will my carryover land, and in which year of the payment schedule?
- How does my state treat capital losses and carryovers?
Harvesting itself is an investment decision for you and your investment adviser. This page describes the tax rules only.
Get the full playbook. The Waterfall Strategy, the 20-minute version and the one-page Cliff Notes, free.
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.