Capital Gains on the Sale of Rental Property

When you sell a rental property, your tax bill depends not just on what you received versus what you paid, but also on years of depreciation deductions you claimed on the way. The IRS demands repayment of those depreciation benefits through a separate tax, called depreciation recapture, which often exceeds the long-term capital gains rate and can make an apparently modest profit feel much costlier.

The basis calculation: where depreciation cuts both ways

When you buy a rental property, your cost basis is what you paid for it. But the moment you place it in service for rental income, depreciation begins. Each year you claim depreciation as a deduction (or your accountant does), the basis shrinks. On sale day, your realized gain is the sale price minus your current adjusted basis.

Here’s the mechanical issue: depreciation deductions lowered your taxable income when you owned the property, but on sale, the IRS reclaims that benefit by including all those deductions back into your gain calculation. A property bought for $300,000 that you sold for $300,000 (nominally break-even) will show a substantial taxable gain if you deducted $50,000 in depreciation—your basis is now $250,000, so you have a $50,000 gain.

Depreciation recapture: the 25% tax on reclaimed deductions

Long-term capital gains on real estate typically enjoy preferential rates (0%, 15%, or 20% federally). Depreciation recapture does not. The IRS taxes the portion of your gain that comes from claimed depreciation at a flat 25% rate federally, regardless of your overall income level. This rate applies only to the depreciation taken; any additional gain above that amount is taxed as long-term capital gain.

Example: You sell a rental for $400,000. Your adjusted basis is $250,000 (original $300,000 minus $50,000 depreciation). Total gain is $150,000. Of this, $50,000 is recapture (the depreciation you claimed), taxed at 25% = $12,500. The remaining $100,000 is long-term capital gain, taxed at your applicable rate (15% if you’re in that bracket) = $15,000. Total federal tax: $27,500.

What gets recaptured: section 1245 vs. section 1250

For residential rental properties, you recapture depreciation claimed after 1986 under Section 1250. In practice, for individual owners of residential rentals, nearly all depreciation claimed becomes recapture at 25%.

Commercial property and personal property (appliances, furnishings, equipment) often fall under Section 1245, where the rules differ slightly, but the headline rate remains 25% for real property depreciation.

Adjusted basis and selling costs

Your adjusted basis is not simply purchase price minus depreciation. You must also add capital improvements made during ownership (a new roof, HVAC system, renovation) and subtract selling costs—broker commissions, attorney fees, inspection costs—directly from the sale proceeds before computing gain.

Capital improvements increase basis. Repairs and maintenance do not. The distinction matters: replacing a roof is an improvement; patching one is a repair. Some investors confuse this line, inflating basis and understating gain.

Long-term vs. short-term: the holding period test

For long-term capital-gain rates to apply, you must have held the property for more than one year. Selling a rental within a year triggers short-term capital gains treatment (ordinary income rates, often steeper) on the non-recapture portion of the gain, in addition to the 25% recapture tax.

The holding period is simple: date of acquisition to date of sale. A few days short of a year can cost thousands in federal tax and shift your income into a higher bracket.

How rental sale gains affect your income and tax brackets

Capital gains from a rental sale increase your adjusted gross income, which can trigger phase-outs of deductions, reduce tax credits, and raise the income threshold for higher marginal tax rates. Net investment income from the sale may also trigger the net investment income tax (3.8% surtax), adding another layer of federal tax if your modified AGI exceeds certain thresholds.

State taxes vary widely. Some states tax all gains uniformly; others separately recapture at their own rates (often lower than federal), and some allow small recapture deductions for long-held property.

The 1031 exchange escape hatch

If you do not want to trigger these taxes, the Internal Revenue Code Section 1031 exchange permits you to defer both depreciation recapture and long-term capital gains if you reinvest the sale proceeds in another investment-grade property of equal or greater value within strict timelines. The depreciation recapture liability does not vanish; it carries forward to the replacement property and becomes due only when you eventually sell without doing another 1031 exchange.

State and local taxes on rental sales

Federal depreciation recapture is 25%, but your state may add its own tax. California, for example, taxes long-term capital gains at ordinary income rates (up to 13.3% state plus federal) but generally does not separate recapture. In contrast, some states have no income tax at all.

If you move between states after the sale, state residency questions arise: where was the property located, and where were you living at time of sale? These rules vary, and high-basis, high-sale-price properties require careful state tax planning.

See also