Quick overview
Selling a rental property creates taxable events that most owners overlook until closing day. Taxes typically fall into two buckets: (1) capital gain (or loss) on the sale, and (2) depreciation recapture for deductions you previously claimed. Both influence how much cash you actually keep. This article explains how the tax math works, common tax rates, reporting forms, planning strategies (including 1031 exchanges), and practical recordkeeping steps.
How gain and adjusted basis are calculated
The taxable gain begins with the property’s adjusted basis and ends with the amount realized.
- Purchase price (plus acquisition costs) + capital improvements = initial basis.
- Subtract cumulative allowable depreciation and casualty loss adjustments to get the adjusted basis.
- Amount realized = sale price minus selling expenses (commissions, title fees).
- Taxable gain = amount realized − adjusted basis.
Example: You bought a duplex for $200,000, made $40,000 in capital improvements, and claimed $30,000 of depreciation. Your adjusted basis is $210,000. If you sell for $350,000 and pay $20,000 in selling costs, your amount realized is $330,000 and your gain is $120,000.
(IRS guidance: Publication 551 and Publication 544 explain basis and dispositions.)
Depreciation recapture: what it is and how it’s taxed
Depreciation you claimed while renting reduces your basis. When you sell, the IRS requires recapture of that depreciation:
- For most residential rental real estate (Section 1250 property), the accumulated depreciation up to the gain amount is treated as “unrecaptured Section 1250 gain” and is taxed at a maximum rate of 25% (not ordinary rates), subject to limitations. In practice, you’ll often see part of the gain taxed at the special 25% rate specifically related to prior depreciation claimed.
- If you sold business property with certain accelerated depreciation previously claimed, some recapture can be taxed as ordinary income under Section 1245. That’s rare for straight-line residential real property but matters for equipment and some nonresidential property.
Put simply: depreciation lowers your taxable gain while you own the property, but the tax cost is deferred and realized on sale—often at the 25% unrecaptured Section 1250 rate for residential rentals (IRS Publication 544, Publication 523).
Capital gains rates and additional taxes
- Short-term capital gains: If you owned the property 1 year or less, gains are short-term and taxed at ordinary federal income tax rates.
- Long-term capital gains: If you owned the property more than 1 year, gains are taxed at long-term capital gains rates—typically 0%, 15%, or 20% depending on taxable income. (IRS Topic: Capital Gains & Losses.)
- Net Investment Income Tax (NIIT): High-income taxpayers may pay an additional 3.8% NIIT on net investment income, which includes rental property gains, if modified adjusted gross income exceeds the thresholds ($200,000 single, $250,000 married filing jointly).
Important interaction: Depreciation recapture taxable at up to 25% is separate from the long-term capital gain rates and may increase total tax on a sale.
Reporting the sale (forms and timeline)
- Report sale of rental real estate on Form 8949 and Schedule D (Form 1040) to show capital gain/loss.
- Report depreciation recapture for most rental real estate as part of gains on Form 4797 and then carry to Schedule D if required—check current IRS instructions because reporting paths vary by property type.
- Keep records: Closing statement (HUD-1 or Closing Disclosure), purchase settlement statement, receipts for capital improvements, depreciation schedules (Form 4562), and prior tax returns.
(Refer to IRS Forms 8949, Schedule D, Form 4797 and Publication 544 for details.)
Common tax-planning strategies when selling rental property
- 1031 exchange (like-kind exchange)
- A properly structured 1031 exchange allows deferral of capital gains and depreciation recapture by reinvesting proceeds into qualifying like-kind real estate. Time limits: identify replacement property within 45 days and close within 180 days. After the Tax Cuts and Jobs Act, 1031 only applies to real property (no personal property). In my practice, 1031 exchanges are a powerful tool to grow a real estate portfolio tax-deferred when the investor plans to keep owning real property. (See IRS guidance on Like-Kind Exchanges and our glossary page on 1031 Exchange.)
- Internal resources: “How to Use 1031 Exchanges in Personal Real Estate Strategies” and “1031 Exchange” explain practical steps and pitfalls (https://finhelp.io/glossary/how-to-use-1031-exchanges-in-personal-real-estate-strategies/, https://finhelp.io/glossary/1031-exchange/).
- Timing sales to a lower-income year
- Long-term capital gains rates and NIIT depend on taxable income. Selling in a year with lower income (retirement year, start of business losses) may reduce or eliminate capital gains tax or NIIT.
- Installment sale
- Spreading the sale proceeds over several years using an installment sale can spread taxable gain and potentially keep you in lower tax brackets across years. Interest rules apply.
- Convert to primary residence (partial exclusion)
- If you live in the property as your primary residence for at least two of the five years before the sale, you may exclude up to $250,000 ($500,000 married filing jointly) of gain under the home-sale exclusion. If you rented the property previously, complex rules apply; the exclusion may be prorated. Consult a tax advisor.
- Charitable remainder trust or donate property
- Donating appreciated property or transferring it into a charitable remainder trust can reduce immediate capital gains and provide income and estate planning benefits.
- Opportunity Zones and other special vehicles
- Investing gain proceeds in a Qualified Opportunity Fund may defer and reduce tax if structured properly. These vehicles have specific timelines and rules.
Practical examples (two scenarios)
Example A — Long-term sale with depreciation recapture
- Purchase: $300,000
- Improvements: $20,000
- Depreciation claimed: $60,000
- Adjusted basis: $260,000
- Sale price: $400,000; selling costs: $20,000 → amount realized $380,000
- Gain: $380,000 − $260,000 = $120,000
- Depreciation recapture portion: $60,000 — taxed up to 25% = $15,000 federal tax (plus state tax and possible NIIT).
- Remaining $60,000 taxed at long-term capital gains rates (0/15/20 depending on income), say 15% → $9,000.
- Total federal tax on gain ≈ $24,000 (plus potential 3.8% NIIT on gain if applicable).
Example B — Using a 1031 exchange
- Same numbers, but seller uses a properly structured like-kind exchange and buys replacement rental property.
- Immediate tax liability on gain and depreciation recapture is deferred—there’s no current federal tax due on the sale if all exchange rules are met, but basis in the new property is adjusted and recapture is deferred until a later taxable disposition.
These simplified examples ignore state taxes, AMT considerations, and potential installment sale interest — get personalized calculations from a tax professional.
Recordkeeping checklist before and after the sale
- Original purchase closing statement and deed
- Closing statement for the sale (HUD-1 or Closing Disclosure)
- Receipts and invoices for capital improvements (roof, HVAC, additions)
- Depreciation schedule (Form 4562 entries) and prior tax returns that show rental income and depreciation
- Repair vs. improvement documentation
- Lease history and proof of rental use
- Communications with tenants regarding notices when selling
Good records reduce audit risk and help calculate accurate basis and depreciation recapture.
Common mistakes investors make
- Failing to track capital improvements and repairs (capital improvements increase basis; repairs do not).
- Overlooking depreciation recapture and assuming only capital gains tax applies.
- Mistiming identification dates for a 1031 exchange or underreserving for taxes at closing.
- Not factoring in state income taxes and NIIT.
In my practice I’ve seen investors leave thousands of dollars on the table by not documenting improvements or by assuming a primary residence exclusion when the property doesn’t qualify.
Next steps and getting professional help
- Run a hypothetical tax calculation before listing the property so you can plan for net proceeds.
- If you’re considering a 1031 exchange, start conversations with a qualified intermediary and a CPA before marketing the property.
- Keep a copy of all closing documents and update your depreciation schedule so your CPA has everything needed to file accurately.
Authoritative sources and where to read more
- IRS, Publication 544, Sales and Other Dispositions of Assets (basis and gain): https://www.irs.gov/forms-pubs/about-publication-544
- IRS, Topic/Guidance on Capital Gains & Losses and Like-Kind Exchanges (Section 1031): https://www.irs.gov/taxtopics and the IRS Like-Kind Exchanges pages
- For depreciation rules and Form 4562: see IRS Publication 946 and Form 4562 instructions.
Additional reading on FinHelp:
- Strategies to reduce tax on capital gains from property sales: https://finhelp.io/glossary/strategies-to-reduce-tax-on-capital-gains-from-property-sales/
- Depreciation recapture and tax reporting for rental sales: https://finhelp.io/glossary/depreciation-recapture/
- How to Use 1031 Exchanges in Personal Real Estate Strategies: https://finhelp.io/glossary/how-to-use-1031-exchanges-in-personal-real-estate-strategies/
Professional disclaimer
This article provides general information and examples for educational purposes and does not constitute tax advice. Tax rules change and individual situations vary—consult a qualified tax professional or CPA before making decisions about selling rental property.
