Quick overview
Selling a rental property usually creates a taxable event. The taxable amount depends on your adjusted basis (original cost plus improvements minus accumulated depreciation), the sale price, and special rules for depreciation recapture and like-kind exchanges. In my CPA practice I see three recurring issues that drive extra tax: missed depreciation records, incorrect reporting on the wrong IRS forms, and poor planning around timing or exchange strategies.
How to calculate your taxable gain (step-by-step)
- Determine gross sale proceeds: the contract sales price minus allowable selling costs (commissions, title fees).
- Compute adjusted basis: original purchase price + capital improvements – cumulative depreciation claimed (or allowable) – casualty losses claimed that reduced basis.
- Subtract adjusted basis from net sale proceeds. The result is your total gain (or loss).
Example: You bought a residential rental for $200,000, claimed $15,000 in depreciation, made $10,000 in capital improvements, and sold it for $300,000 with $15,000 in selling costs:
- Adjusted basis = $200,000 + $10,000 – $15,000 = $195,000
- Net sale proceeds = $300,000 – $15,000 = $285,000
- Total gain = $285,000 – $195,000 = $90,000
That $90,000 will be allocated between (A) any depreciation recapture portion and (B) capital gain (long-term or short-term depending on holding period).
Depreciation recapture and how it’s taxed
Depreciation you claimed (or were allowed to claim) reduces basis and increases taxable gain when you sell. For most residential rental real estate, the portion of gain attributable to prior depreciation is subject to special tax treatment:
- Unrecaptured Section 1250 gain: up to the amount of prior straight-line depreciation on real property, that portion is generally taxed at a maximum 25% rate (not the lower long-term capital gains rates). See IRS Publication 544 and the instructions to Form 4797 for details (IRS: Publication 544; Form 4797 Instructions).
- Any remaining gain above the depreciation-allocated amount is taxed as capital gain (0%, 15%, or 20% federal long-term rates depending on taxable income). High-income taxpayers may also owe the 3.8% Net Investment Income Tax (NIIT).
Practical note: If you misstated depreciation in prior returns, the IRS can adjust recapture. Keep clear depreciation schedules (Form 4562 entries) to substantiate amounts.
Reporting: which forms you’ll use
- Form 1099-S: You may receive this if the closing agent reported the sale; it does not replace your obligation to report the transaction.
- Form 8949 and Schedule D (Form 1040): Most capital gains and losses from sale of real estate are reported here, especially the capital-gain portion of the sale.
- Form 4797 (Sales of Business Property): Use this form to report the portion of gain that is treated as ordinary income for depreciation recapture or if the property was used in a trade or business (certain parts of the recapture rules flow through Form 4797). Instructions: see IRS Form 4797.
How it flows in practice: You typically calculate the gain, separate the depreciation portion and report that on Form 4797 as ordinary income or unrecaptured Section 1250 gain (per the instructions). The capital gain portion is reported on Form 8949 and summarized on Schedule D. When in doubt, follow the Form 8949 and Form 4797 instructions and reconcile figures on Schedule D.
Sources: IRS instructions for Forms 8949, Schedule D, and Form 4797; Publication 544 (Sales and Other Dispositions of Assets) and Publication 523 (Selling Your Home) for primary-residence rules.
Common exemptions, deferrals, and planning opportunities
- Section 121 exclusion (primary residence): If you converted a rental to your primary residence and lived there 2 of the last 5 years before sale, you may exclude up to $250,000 of gain ($500,000 married filing jointly) under IRC §121, subject to rules and prorations for periods of nonqualified use. See IRS Publication 523.
- 1031 like-kind (tax-deferred) exchange: If you reinvest proceeds into qualified replacement real property and meet strict timing and identification rules, you can defer capital gains tax (but not necessarily NIIT). Properly structured 1031 exchanges require a qualified intermediary and careful documentation; see more in our glossary on 1031 Exchange. (Internal link: 1031 Exchange: https://finhelp.io/glossary/1031-exchange/)
- Installment sale: Spreading payments across years may spread the recognition of gain and the tax impact, though depreciation recapture generally must be recognized in the year of sale (with some exceptions).
Practical tip: A 1031 exchange defers taxes, it does not eliminate depreciation recapture forever. When you ultimately cash out (sell for non-like-kind property), recapture and capital gains will be recognized.
Examples to illustrate tax outcomes
Example A — Full capital gain and recapture: Using the earlier numbers with a $90,000 total gain and $15,000 depreciation claimed:
- $15,000 is treated under recapture rules (maximum 25% tax on unrecaptured Section 1250).
- Remaining $75,000 is long-term capital gain if your holding period was >1 year and is taxed at your long-term capital gains rate.
Example B — Using Section 121 after conversion: If you lived in the rental for 2 of the last 5 years and otherwise qualify, you may exclude up to $250,000 ($500,000 MFJ) of gain; however, the portion attributable to depreciation after May 6, 1997 cannot be excluded and remains taxable as recapture.
Mistakes I see in practice (and how to avoid them)
- Not tracking improvements vs. repairs. Only capital improvements increase basis; routine repairs do not. Keep receipts and contractor invoices.
- Forgetting that depreciation recapture can’t generally be avoided by timing alone. Even after conversion to a personal residence, depreciation taken after 1997 generally remains taxable.
- Using a 1031 exchange without a qualified intermediary or missing the 45/180-day identification/completion windows. A failed exchange triggers immediate tax.
Checklist of documents to gather before you sell
- Closing statements (HUD-1 or ALTA/Closing Disclosure)
- Original purchase contract and closing docs
- Records of capital improvements (invoices, canceled checks)
- Depreciation schedules (Form 4562 and prior tax returns)
- Any Form 1099-S received
- Loan payoff statements and seller-related closing costs
Practical tax-planning steps
- Reconcile your depreciation schedule with tax returns and fix errors before the sale if possible.
- Time the sale if your taxable income will be unusually low in a future year to access a lower capital-gains bracket.
- Explore a 1031 exchange early—identify replacement property within 45 days and complete within 180 days.
- Budget for state taxes and NIIT where applicable—many states tax capital gains as ordinary income.
Internal resources
- For more on deferral mechanics and the strict rules for exchanges, see our 1031 Exchange glossary: 1031 Exchange (https://finhelp.io/glossary/1031-exchange/).
- For the mechanics of recapture and how depreciation affects sales, see Depreciation Recapture (https://finhelp.io/glossary/depreciation-recapture/).
- For broader capital gains rates and planning, see Capital Gains Tax (https://finhelp.io/glossary/capital-gains-tax/).
Final notes and professional disclaimer
This article explains common federal tax consequences as of 2025 but is educational only—not individualized tax advice. State tax treatment, local rules, and special circumstances (partnerships, estates, corporations) can change outcomes materially. In my CPA practice I recommend you run proposed sales through a trusted tax preparer or tax attorney and consider requesting a private letter ruling for unusually large or complex transactions.
Author: CPA with 15+ years advising real estate investors and property owners.
Authoritative sources and IRS references:
- IRS Publication 544, Sales and Other Dispositions of Assets: https://www.irs.gov/pub/irs-pdf/p544.pdf
- IRS Form 4797 and instructions: https://www.irs.gov/forms-pubs/about-form-4797
- IRS instructions for Form 8949 and Schedule D: https://www.irs.gov/forms-pubs/about-form-8949 and https://www.irs.gov/forms-pubs/about-schedule-d
- IRS Publication 523, Selling Your Home (for Section 121 rules): https://www.irs.gov/pub/irs-pdf/p523.pdf
Always consult a qualified tax advisor about your particular facts before completing a sale or exchange.