Kinds of Taxes You’ll Pay (and How Much) When Selling a Rental Property

Selling Rental Property? Taxes You Might Owe

Selling a rental property can be a big milestone, but it’s important to understand the various taxes that may apply to ensure you’re prepared for any financial obligations. This article delves into the primary taxes associated with selling investment property, including capital gains taxes and depreciation recapture, and offers strategies to potentially minimize these liabilities.

Capital Gains Tax

If you sell a rental property for more than its adjusted basis, the gain is a capital gain, and it is taxable. The tax rate depends on how long you have owned the property and on your taxable income.

Short-Term vs. Long-Term Capital Gains

• Short-Term Capital Gains: If you’ve owned the property for one year or less, any profit is classified as a short-term capital gain and is taxed at your ordinary income tax rate, which can be as high as 37% in 2025.
• Long-Term Capital Gains: For properties held over one year, gains are considered long-term capital gains. As of 2025, long-term capital gains are taxed at 0%, 15%, or 20%, depending on your taxable income and filing status. For instance, married couples filing jointly with taxable income of $94,050 or less may qualify for the 0% rate, but couples with higher incomes could be taxed at the 15% or 20% rates.

Calculating Capital Gains

To determine your capital gain:

1. Calculate the Adjusted Basis: Start with the original purchase price, add any capital improvements made during ownership, and subtract any depreciation claimed. 
2. Determine the Net Sales Price: This is the selling price minus any selling expenses, such as agent commissions and closing costs.
3. Compute the Capital Gain: Subtract the adjusted basis from the net sales price.

For example, take a look at this breakdown of calculating capital gain:

• Original Purchase Price: $200,000
• Capital Improvements: $20,000 
• Depreciation Claimed: $30,000
• Adjusted Basis: $200,000 + $20,000 – $30,000 = $190,000
• Selling Price: $300,000
• Selling Expenses: $20,000 
• Net Sales Price: $300,000 – $20,000 = $280,000
• Capital Gain: $280,000 – $190,000 = $90,000

In this case, the $90,000 gain would be taxable as long-term capital gains if the property had been owned for more than a year.

Depreciation Recapture

Depreciation enables you to deduct the value of the property as a tax deduction over its useful life, which is typically 27.5 years for a rental home. This reduction in taxable income yearly is one of the greatest benefits of having rental real estate.

The IRS does not let this benefit go on indefinitely, and you will have to “recapture” the depreciation when you sell the property. That is, the depreciation amount you kept deducting year after year has to be repaid to the IRS one way or another, in the form of a recapture tax on depreciation.

This recaptured sum is taxed as ordinary income, up to a rate of 25%, based on your tax bracket at the time of sale.

For instance, if you’d claimed $30,000 in depreciation over the years, you’d recapture this amount at your ordinary income tax rate, but no more than 25%. If your ordinary tax rate is 24%, you’d owe $7,200 in depreciation recapture tax ($30,000 × 24%).

Net Investment Income Tax (NIIT)

In addition to capital gains and depreciation recapture taxes, you may be subject to the Net Investment Income Tax, an additional 3.8% tax on investment income, including gains from the sale of rental property. This applies if your modified adjusted gross income exceeds certain thresholds, according to the IRS:

1. Married Filing Jointly: $250,000
2. Single or Head of Household: $200,000
3. Married Filing Separately: $125,000

Imagine you’re a single filer with a modified adjusted gross income of $210,000, and $20,000 of that is from the sale of a rental property, the NIIT would apply to the $10,000 exceeding the $200,000 threshold. You’d owe an additional $380 ($10,000 x 3.8%) in NIIT.

How Does Basis Work?

Basis refers to the amount of money you’ve invested in the property, which serves as the starting point for determining gain or loss at the time of sale.

The cost basis is generally the original purchase price of the property, plus certain costs associated with acquiring the property—such as closing costs and capital improvements. Over time, the basis can be adjusted, either increasing or decreasing depending on how the property is managed or altered. When it comes time for the sale of residential rental property, the adjusted basis is used to calculate your total capital gain (or loss).

The IRS explains basis and adjusted basis in detail in Publication 551, and it’s a foundational concept in determining your taxes on sale of rental property.

What Increases Cost Basis?

These costs and improvements increase the value of your investment and, therefore, increase your basis:

1. Inspection and appraisal fees
2. Recording fees and owner’s title insurance
3. Real estate commissions paid at purchase
4. Capital improvements such as room additions, new roofs, HVAC system upgrades, or remodels
5. Local assessments for things like street paving, sidewalks, or sewer line installations that improve the property value

What Decreases Cost Basis?

Other actions or events reduce your property’s basis, often resulting in a higher taxable gain upon sale:

1. Depreciation deductions taken during the life of the property
2. Payments received for easements or partial property rights granted
3. Insurance reimbursements or tax deductions from casualty or theft losses
4. Tax credits that affect basis, such as rehabilitation or energy-efficiency credits

Why Basis is Important

When selling rental property, the adjusted basis is subtracted from the sale price (minus closing costs) to calculate your capital gain. A lower adjusted basis (due to depreciation and other deductions) leads to a higher gain and therefore higher selling rental property taxes.

Knowing Your State Taxes

Beyond federal taxes, many states impose their own taxes on capital gains from the sale of residential rental property. State tax rates and rules vary, so it’s important to familiarize yourself with your state’s regulations to understand your total tax liability and reach out to a tax professional with questions.

For example, California taxes capital gains as regular income, with rates ranging from 1% to 13.3%, depending on your income bracket. This means a high-income investor selling a rental property in California could face combined federal and state taxes exceeding 33%.

Another example is Illinois. Illinois has a flat state income tax rate of 4.95%, which applies to all income, including capital gains. While not as steep as California, it’s still a notable addition to your federal tax bill.

Strategies to Minimize Tax Liability

Understanding the taxes on the sale of rental property is important, but there are strategies to potentially reduce or defer these taxes:

Utilize a 1031 Exchange

A 1031 exchange, named after Section 1031 of the Internal Revenue Code, allows you to defer capital gains and depreciation recapture taxes by reinvesting the proceeds from the sale into a like-kind property. To qualify, you must meet these requirements:

1. Like-Kind Property: The replacement property must be of equal or greater value and used for business or investment purposes.
2. Identification Period: You have 45 days from the sale date to identify potential replacement properties.
3. Closing Period: The new property must be purchased within 180 days of the sale.

Engaging a qualified intermediary is essential to facilitate the exchange and ensure compliance with IRS rules.

Convert the Property to a Primary Residence

If feasible, consider converting your rental property into your primary residence. By living in the property for at least two of the five years preceding the sale, you may exclude up to $250,000 of capital gains if single, or $500,000

Tax Harvesting

Tax-loss harvesting must be planned strategically and completed before the end of the calendar year. This involves selling underperforming assets in the same year you sell your rental property.

The IRS allows you to use capital losses to offset capital gains. So, if you made $75,000 in capital gains from the sale of residential rental property but realized a $25,000 loss from selling a stock, your net capital gain would be $50,000. This could result in thousands of dollars in tax savings, depending on your capital gains rate.

Final Thoughts

Understanding the taxes involved in selling a rental property is essential to avoid surprises and make informed financial decisions. From capital gains and depreciation recapture to state taxes and the Net Investment Income Tax, each element impacts your overall profit. Fortunately, strategies like 1031 exchanges, converting the property to a primary residence, and tax-loss harvesting can help reduce or defer these liabilities.

FAQs

​What are capital gains taxes when selling a rental property?

Capital gains taxes apply when you sell a property for more than its adjusted basis. The rate depends on how long you’ve owned the property and your taxable income. Short-term gains are taxed as ordinary income, while long-term gains may be taxed at 0%, 15%, or 20%.

How does depreciation recapture work?

Depreciation recapture occurs when you sell a rental property. The IRS requires you to repay the depreciation benefits you received. This amount is taxed as ordinary income, up to a rate of 25%.

What is the Net Investment Income Tax (NIIT)?

The NIIT is an additional 3.8% tax on investment income, including gains from rental property sales. It applies if your modified adjusted gross income exceeds certain thresholds, such as $200,000 for single filers.

How can a 1031 exchange help minimize tax liability?

A 1031 exchange allows you to defer capital gains and depreciation recapture taxes by reinvesting the proceeds into a similar property. You must meet specific requirements, like identifying a new property within 45 days and completing the purchase within 180 days.

Can converting a rental property to a primary residence impact taxes?

Yes, living in the property for at least two of the five years before selling can allow you to exclude up to $250,000 of capital gains if single, or $500,000 if married filing jointly.