Quick overview
Selling a rental property triggers three main tax results you must report: (1) capital gain or loss, (2) depreciation recapture (unrecaptured Section 1250 gain for most real property), and (3) any ordinary-income items (like depreciation recapture treated as ordinary income on Form 4797). In my practice, missing a single improvement invoice or misreporting depreciation is the most common cause of an unexpected tax bill.
(Authoritative guidance: IRS Publication 527 (Residential Rental Property), Form 4797 instructions, and Publication 544.)
How to calculate gain or loss (step-by-step)
- Determine the amount realized: selling price minus selling expenses (broker fees, advertising, title fees).
- Calculate the adjusted basis: original purchase price + capital improvements − total depreciation claimed while the property was rented.
- Subtract adjusted basis from the amount realized:
- Positive result = gain
- Negative result = loss
Note: Routine repairs are current-year expenses; capital improvements (roof, addition, new HVAC) increase basis. Keep receipts and contractor invoices—these directly reduce taxable gain.
Example (simple):
- Purchase price: $200,000
- Capital improvements: $50,000
- Depreciation claimed: $30,000
- Selling price: $300,000
- Selling costs: $5,000
Amount realized = $300,000 − $5,000 = $295,000
Adjusted basis = $200,000 + $50,000 − $30,000 = $220,000
Gain = $295,000 − $220,000 = $75,000
This $75,000 is your total gain before separating depreciation recapture and capital gain.
What is depreciation recapture and how is it taxed?
Depreciation recapture means the IRS “recaptures” the tax benefit you received from depreciation deductions while the property was used as a rental. For most residential rental real estate, that recaptured portion is treated as unrecaptured Section 1250 gain and can be taxed at a maximum rate of 25% for noncorporate taxpayers. The mechanics are:
- Calculate total gain as above.
- Identify the portion of the gain that is attributable to depreciation taken (or allowed): that portion is subject to recapture rules.
- The recaptured amount is generally taxed at ordinary income rates to the extent of accelerated depreciation for certain property types, but for most straight-line depreciation on real property the recapture is taxed at up to 25% (see IRS guidance on unrecaptured Section 1250 gain).
Practically: if your $75,000 gain includes $30,000 of depreciation previously claimed, some or all of that $30,000 will be taxed under the recapture rules — either as ordinary income (via Form 4797) or as unrecaptured Section 1250 gain taxed up to 25% when reported on Schedule D/Form 8949. (IRS Form 4797 instructions; IRS Publication 527.)
Which IRS forms do you use to report the sale?
- Form 4797 (Sales of Business Property): used to report gain attributable to depreciation recapture and to convert gain into capital gain where applicable.
- Form 8949 and Schedule D (Capital Gains and Losses): report long-term capital gain or loss from the sale after depreciation-related adjustments.
- Form 6252 (Installment Sale): if you sell on an installment basis and elect installment reporting, use Form 6252 to report payments and gain spread over years.
Sequence in practice:
- Report the sale on Form 4797 to account for depreciation recapture. Part III of Form 4797 generally handles Section 1250.
- Any remaining gain that qualifies as capital gain goes to Form 8949 and Schedule D.
(See official instructions: IRS Form 4797; IRS Publication 544.)
Special situations and rules to watch
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Conversion from personal residence to rental: When you convert your home to rental, your basis carries over, and you must compute depreciation from the conversion date. The primary-residence exclusion (Section 121) may be available in limited circumstances for a portion of the gain—consult a tax advisor (IRS Topic No. 701; Pub. 527).
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1031 Exchanges: If you reinvest sale proceeds into qualifying like-kind investment property, you may be able to defer recognition of capital gain through a 1031 exchange. This is a complex, time-sensitive strategy that requires a qualified intermediary and strict timelines. See our internal guide on 1031 exchanges for nuances and practical steps: 1031 Exchange.
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State taxes: State taxable treatment of recapture and capital gains varies—always check state rules and filing requirements.
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Installment sales: Selling on terms spreads recognition of gain. Depreciation recapture may still be recognized in the year of sale, even if payments are received later—confirm with a tax professional.
Real-world tips I use with clients
- Keep organized records: Maintain a folder (digital + physical) for purchase paperwork, closing statements, improvement invoices, depreciation schedules (Form 4562), and lease records. These documents support your adjusted basis and depreciation taken.
- Reconcile depreciation schedules annually: When you sell years later, reconcile total depreciation claimed with your tax returns and Form 4562.
- Plan timing: If possible, time sales for years when you expect lower taxable income to reduce taxable gain rates.
- Consider deferred strategies: A properly executed 1031 exchange can defer tax; however, it doesn’t eliminate recapture forever—consult a qualified intermediary and tax advisor early.
- Review seller-paid expenses: Commonly missed selling costs (title, prep, advertising) reduce amount realized and therefore taxable gain.
Internal resources: for a practical walkthrough on deferring gains via reinvestment, see our 1031 Exchange article and our Depreciation Recapture glossary for deeper rules and examples.
Common mistakes and how to avoid them
- Forgetting capital improvements: Homeowners often deduct routine repairs as improvements; they are not. Only capital investments that add value or extend useful life increase basis.
- Mixing personal and rental records: For conversions, separate personal-use expenses from rental expenses to avoid overstating basis or improper deductions.
- Missing depreciation recapture: Some sellers assume all gains are taxed at long-term capital gains rates. Depreciation recapture often increases tax liability.
- No professional review: Complex sales (multiple properties, installment sales, exchanges) benefit materially from CPA or tax attorney review.
Short checklist before you file
- Gather closing statement (settlement sheet) and proof of selling expenses.
- Compile purchase documents and records of capital improvements.
- Assemble annual depreciation schedules and Form 4562 copies.
- Confirm whether a 1031 exchange or installment sale applies.
- Consult a CPA to prepare Form 4797, Form 8949, and Schedule D.
Frequently asked questions
Q: How long must I keep records of improvements and depreciation?
A: Keep records for at least three years after filing the return that reports the sale, but ideally retain them permanently or until the statute of limitations expires for that tax year. Good practice: keep purchase, improvement, and depreciation records for the life of ownership plus three years. (See IRS recordkeeping guidance.)
Q: Can I avoid depreciation recapture?
A: Not typically. Depreciation claimed while you owned the property is generally recaptured on sale. A 1031 exchange can defer recognition, but it does not eliminate the economic effect forever—future disposition will trigger recognition unless another deferment is used.
Q: Are depreciation recapture rates higher than capital gains rates?
A: Yes. Unrecaptured Section 1250 gain on real property is subject to a maximum rate of 25% for noncorporate taxpayers, which can be higher than the typical long-term capital gains rates (0%, 15%, or 20%).
Final notes and professional disclaimer
This article explains common federal tax rules relevant to U.S. rental property sales and cites IRS guidance (IRS Publication 527; Form 4797 instructions; Publication 544). Tax laws and state rules change; treat this page as educational, not personalized tax advice. In my professional experience, an early consultation with a CPA or tax attorney—before you list the property—reduces surprises and optimizes net proceeds.
Internal links for deeper reading:
- 1031 Exchange — https://finhelp.io/glossary/1031-exchange/
- Depreciation Recapture — https://finhelp.io/glossary/depreciation-recapture/
- Tax Consequences of Selling Rental Property: Reporting and Exemptions — https://finhelp.io/glossary/tax-consequences-of-selling-rental-property-reporting-and-exemptions/
Authoritative sources:
- IRS Publication 527, Residential Rental Property (Income and Expenses)
- IRS Form 4797 instructions (Sales of Business Property)
- IRS Publication 544, Sales and Other Dispositions of Assets
This content is educational and should not replace individualized advice from a qualified tax professional.
