Real Estate Exits, Losses, and Foreclosures: What High Earners Need to Know About Taxes

The Tax Framework Every Investor Should Understand

Before diving into exits, you need one core framework. Every dollar you make or lose is defined by two factors.

1. The source of income

Examples include capital gains from selling an asset, rental real estate income, business income, and ordinary income.

2. The activity type

Most passive real estate investors fall into the passive category rather than active.

Why this matters is simple. Losses generally can only offset gains in the same category. This is why many investors are surprised at tax time, even when they believe they lost money.

When a Real Estate Deal Exits at a Profit

Consider a straightforward example.

• Investment: $100,000
  
  
• Total return: $150,000
  
  
• Gain: $50,000
  
  

That $50,000 is rarely taxed as one clean number.

Capital Gains

Most profitable real estate exits generate long-term capital gains. These are typically taxed at preferential rates compared to ordinary income, assuming the investment was held long enough.

Depreciation Recapture

If the property claimed depreciation while you held it, part of your gain may be taxed as depreciation recapture.

In simple terms, you received tax deductions in earlier years, and the IRS recaptures some of that benefit when you sell. This portion is often taxed at higher rates than capital gains, though still differently than W-2 income.

An important nuance is that if you did not actually benefit from depreciation, such as when losses were suspended and carried forward, the recapture impact may be reduced.

Using Losses From Other Deals to Reduce Exit Taxes

If you have passive losses from other real estate investments, you may be able to use them to offset gains from a profitable exit.

This is where advanced planning matters. Using losses today means you will have fewer losses available later, but deferring taxes now can significantly improve long-term net worth.

Many high earners think of this as an interest-free loan from the IRS. You keep capital working instead of sending it to the government immediately.

Timing Matters More Than Tax Rates

High earners often focus on tax rates, but timing can be more powerful.

A career transition, a temporary reduction in income, a sabbatical, or a slow business year can all change the optimal tax strategy. In lower-income years, paying some tax may be cheaper than burning valuable losses. In higher-income years, deferring gains can be far more impactful.

Tax strategy should align with future income expectations, not just the current year’s return.

When a Deal Goes Bad: Foreclosure and Failed Investments

Foreclosure is financially painful, but tax treatment is more complex than most investors expect.

Foreclosure Is Treated Like a Sale

Even if you did not choose to sell, the IRS generally treats foreclosure as a disposition of the asset.

Debt Forgiveness Can Reduce Losses

If the property is underwater, part of the loss may be reduced by cancellation of debt.

For example, if a property is worth $45 million and has $50 million of debt, the $5 million difference may reduce the total loss passed through to investors. This usually does not create an out-of-pocket tax bill, but it can significantly limit how much loss you are able to claim.

Fair market value at foreclosure is critical and is typically determined and reported by the lender.

Why Large Losses Can Take Years to Use

If a loss is classified as a capital loss, the rules are restrictive.

Capital losses fully offset capital gains, but only $3,000 per year can offset ordinary income. The remainder carries forward indefinitely.

This is why investors with large losses from failed deals often feel stuck. The practical solution is not forcing losses to become active, but planning future capital gains that can absorb them.

What Smart Investors Do Next

Business owners and high earners with real estate exposure should take several proactive steps.

First, review K-1s carefully and look at capital accounts, income categories, and footnotes. Second, track suspended and carried-forward losses on the personal return, since they do not always appear clearly on the K-1. Third, ask sponsors about fair market value if a deal is distressed. Finally, plan exits around future income, not just current tax rates.

Final Takeaway

Real estate tax outcomes are determined long before a deal ends. Profitable exits, failed investments, and foreclosures all follow different tax rules. The difference between reactive filing and proactive planning can be substantial.

For high earners, the goal is not just minimizing taxes. It is controlling when and how they show up.