Dear Tax Talk,

We took a second (mortgage) out on our primary residence to buy a rental property. A job change made us move, so we had to sell the rental property for less than what we paid for it (our second mortgage). We'd like to take that money and instead of putting it back toward the second loan, rather use it as a down payment for a new primary residence in our new state. (We are currently renting out our original primary residence since the market leaves us underwater there.) Do we have to pay capital gains tax on the money from the sale of the rental since it's not really a gain?
-- Melissa

Dear Melissa,
Many people mistake sales proceeds for gain on a sale of an asset. Because you own the rental free and clear, you stand to receive all the proceeds from the sale. Whether you repay the second mortgage with these proceeds does not change your taxable gain or loss on the sale of the rental. Because you are selling for less than your original cost, you will have a capital loss for tax purposes. In figuring your cost, you use the original cost including any amounts borrowed directly or indirectly to buy or improve the property.

Because it was a rental property rather than a personal residence, you can deduct the loss, which would be ordinary (i.e., not subject to the capital loss limitations). Use Form 4797 to report the loss. The tax deduction will help take some of the sting out of the loss. It is hoped your new home will appreciate enough so that you can repay the second mortgage, and if you keep it as your home for more than two years, the gain would be tax-free. That's like having your cake and eating it, too!