How the sale of a rental is taxed
Gain = sale price − selling costs − (purchase price + improvements − depreciation)
When you sell a rental, the gain is measured against your adjusted basis: what you paid, plus capitalized closing costs and improvements, minus all the depreciation you took or were allowed to take. Depreciation lowers your basis, so it increases the gain when you sell.
Two layers of federal tax
- Depreciation recapture. The part of the gain that comes from depreciation, called unrecaptured section 1250 gain, is taxed at your ordinary rate up to a maximum of 25%.
- Long-term capital gain. The rest of the gain is taxed at 0%, 15% or 20%, depending on your taxable income, if you owned the property for more than one year.
Higher earners may also owe the 3.8% net investment income tax, and most states tax the gain as income.
A worked example
You bought a rental for $300,000, added $15,000 of closing costs and improvements, and took $52,000 of depreciation. Your adjusted basis is $263,000. You sell for $420,000 and pay 6% in selling costs, leaving $394,800. The gain is $131,800: $52,000 is taxed at up to 25% ($13,000) and the remaining $79,800 at 15% ($11,970), about $24,970 of federal tax before any state tax.
Ways investors defer or reduce the tax
A like-kind exchange under section 1031 can defer the tax if you reinvest in another investment property under strict timing rules. Selling in a low-income year can lower the rate. If the home was your main residence for two of the last five years, part of the gain may qualify for the home sale exclusion, but depreciation taken after May 6, 1997 is still taxed.
This is an estimate for a property held more than one year. It does not model suspended passive losses, installment sales or state rules. See IRS Topic 409 and Publication 544, and confirm with a tax professional before you sell. To estimate depreciation, use the depreciation calculator.