Thank you for using jutanswer. You're on the right track, but you seem to have capital losses and business losses slightly confused.
Since your friend changed the property from her personal residence to business property, the sale of the home will in fact be reported on Form 4797 as 1231 business loss. HOWEVER, since this is a business loss, she is NOT restricted to just $3000 in loss. She will report the loss in full in the year she sold the property. Please see below:
Instructions for Form 4797
Since she is reporting the loss on the sale of a rental home (which is now business property) on Form 4797, Sales of Business Property, then the loss on the sale of the rental property is added to the Schedule E. The same IRS Code 172 covers this also.
One note: if your friend is now retired, and her income will be less now than it was in the past, she might want to re-consider waiving the 2 year carry back time, since it may give her a better benefit to carry it back while she was working as opposed to carrying it forward when her income will be less.
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