With the current economic and housing conditions, selling a rental property for a loss is a common occurrence. And at times the loss is so great that it eclipses your taxable income. Provided you held the property for more than a year, the sale will be considered a Section 1231 loss.
A Section 1231 loss can be used to reduce any type of income such as W-2 income from a job, self-employment income, capital gains, etc. Further, if the loss reduces your taxable income below zero, you have a Net Operating Loss (NOL).
If you have a NOL you can go back two years to apply it against taxable income in the past, or carry it forward for up to twenty years to offset future taxable income. To apply a Net Operating Loss to prior tax returns, a Form 1040X (amended tax return) or Form 1045 (application for tentative refund). Form 1045 can be faster, but has stricter filing deadlines. Our advice is generally to take the net operating losses in future years unless there are strong compelling reasons to amend prior tax returns.