Selling a leasehold interest triggers federal capital gains tax on the profit, the same way selling any other real estate does. The capital gains tax on the sale of a leasehold property applies to the difference between what you paid (adjusted for improvements and any depreciation) and what you netted at closing. If the leasehold was your primary home, the Section 121 exclusion may wipe the tax out entirely. If it was a rental or business property, expect depreciation recapture on top of the capital gains rate. Long-term federal rates run from 0% to 20%, plus a possible 3.8% surtax for high earners.
When the Sale Is Tax-Free
The biggest tax break available is the Section 121 exclusion, which lets you exclude up to $250,000 of gain ($500,000 for married couples filing jointly) if the property was your principal residence.1Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence To qualify, you must meet both tests during the five-year period ending on the sale date:
- Ownership test: you owned the property for at least two years total. For joint filers, only one spouse needs to meet this.
- Use test: you lived in the property as your main home for at least two years total. The 730 days don’t need to be consecutive. Both spouses must independently satisfy this test on a joint return.2Internal Revenue Service. Publication 523 – Selling Your Home
The exclusion applies to leaseholds, not just fee simple ownership. The statute explicitly covers tenant-stockholders in cooperative housing corporations, treating their stock ownership as meeting the holding requirement and their occupancy as meeting the use requirement.3Office of the Law Revision Counsel. 26 U.S. Code 121 – Exclusion of Gain From Sale of Principal Residence – Section d4 More broadly, any leasehold you own and live in as your primary home qualifies, because the statute refers to “property” without limiting it to full ownership.
If your gain falls below the exclusion amount and you meet both tests, you owe zero federal capital gains tax and typically don’t need to report the sale at all (unless you receive a Form 1099-S at closing).
Partial Exclusion Situations
The exclusion shrinks in a few common scenarios. If you rented the leasehold out for part of your ownership period, only the portion of gain attributable to residential use qualifies. If you claimed a home office deduction, the depreciation taken on that portion must be recaptured even when the rest of the gain is excluded. If you fall short of the two-year ownership or use test because of a job relocation, health issue, or other qualifying circumstance, you may still claim a prorated exclusion.2Internal Revenue Service. Publication 523 – Selling Your Home
2026 Capital Gains Tax Rates
When the exclusion doesn’t apply or doesn’t cover the full gain, the rate depends on how long you held the leasehold and your total taxable income.
Long-Term Rates (Held More Than One Year)
- 0%: taxable income up to $49,450 (single), $98,900 (married filing jointly), or $66,200 (head of household)
- 15%: income above those thresholds up to $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household)
- 20%: income above $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household)
Short-Term Rates (Held One Year or Less)
Gain is taxed as ordinary income. For 2026, federal ordinary rates run from 10% to 37% depending on filing status and total taxable income.
Net Investment Income Tax
High earners face an additional 3.8% Net Investment Income Tax on capital gains. The surtax kicks in when modified adjusted gross income exceeds $200,000 (single), $250,000 (married filing jointly), or $125,000 (married filing separately). The 3.8% applies to the lesser of your net investment income or the amount by which your income exceeds the threshold. On a large gain, the top effective federal rate reaches 23.8% before state taxes.
Depreciation Recapture on Rental and Business Leaseholds
This is where leasehold sales catch landlords off guard. If you rented the property or used it in a business, you were required to depreciate improvements over their recovery period. Residential rental property improvements are depreciated over 27.5 years under the Modified Accelerated Cost Recovery System.4Internal Revenue Service. Publication 946 – How to Depreciate Property At sale, the IRS wants some of that depreciation back.
The portion of your gain attributable to straight-line depreciation you previously claimed is taxed as “unrecaptured Section 1250 gain” at a maximum rate of 25%, regardless of your income bracket. Only the gain above the depreciation amount gets the regular long-term rate. On a $200,000 total gain with $80,000 of prior depreciation, the first $80,000 is taxed at up to 25%, and the remaining $120,000 at your applicable long-term rate.
A costly mistake: skipping depreciation deductions during ownership doesn’t save you from recapture at sale. The IRS taxes depreciation “allowed or allowable,” meaning you owe recapture on the depreciation you should have taken even if you never claimed it.
Calculating Your Gain
Your taxable gain is the sale price minus your adjusted basis and selling expenses. Getting the basis right is where most errors happen.
Starting Basis
Your starting basis is generally what you paid for the leasehold, including the purchase price and closing costs like title insurance and attorney fees.5Internal Revenue Service. Publication 551 – Basis of Assets For an inherited leasehold, basis is typically the fair market value on the date of the prior owner’s death. For a gifted leasehold, you generally take the donor’s basis.
Improvements That Increase Basis
Capital improvements increase basis and reduce your taxable gain: structural additions, renovations that extend the property’s useful life, and significant system upgrades like new HVAC or plumbing. The improvement must add lasting value rather than maintain existing condition. Repainting a room doesn’t count; adding a room does.5Internal Revenue Service. Publication 551 – Basis of Assets
For leaseholders specifically, the cost of extending a lease term is treated as an improvement and increases your basis. Lease extensions can be expensive, and that expense directly reduces your eventual tax bill.
Adjustments That Decrease Basis
Depreciation claimed (or allowable) on rental or business-use property reduces your basis. Claim $50,000 of depreciation over 10 years and your basis drops by $50,000, raising your eventual gain by the same amount. Casualty loss deductions and insurance reimbursements also reduce basis. Any amortization you took on lease acquisition costs under Section 178 reduces basis as well.6Office of the Law Revision Counsel. 26 U.S. Code 197 – Amortization of Goodwill and Certain Other Intangibles
Selling Expenses
You can subtract the costs of selling from your proceeds. Broker commissions, attorney fees, transfer taxes, and title insurance at closing all reduce your taxable gain. Routine ownership costs like maintenance, ground rent, and property management fees do not.
Deferring the Tax With a 1031 Exchange
If you’re selling a leasehold held for investment or business use, a Section 1031 like-kind exchange lets you defer the entire capital gains tax by reinvesting into another qualifying property. The replacement must also be held for investment or business use; you can’t exchange a rental into your new primary residence.
Leasehold interests qualify with a limitation. Treasury regulations treat a leasehold with 30 or more years remaining as like-kind to a fee simple interest in real property.7eCFR. 26 CFR 1.1031(a)-1 – Property Held for Productive Use in Trade or Business A leasehold with fewer than 30 years remaining is on shakier ground, and case law has generally not supported exchanging a short-term leasehold for a fee interest. Get professional advice before attempting one.
The timelines are strict. You have 45 days from the sale of the relinquished property to identify up to three potential replacements, and 180 days to close the exchange.8Internal Revenue Service. Like-Kind Exchanges Under IRC Section 1031 Miss either deadline and the entire gain becomes taxable. A qualified intermediary must hold the proceeds during the exchange; if the money touches your hands, the exchange fails.
How to Report and Pay
For a personal-use leasehold, report the sale on Form 8949 and carry the totals to Schedule D of Form 1040. The IRS cross-references Form 8949 against the Form 1099-S filed by the closing agent.9Internal Revenue Service. About Form 8949 – Sales and Other Dispositions of Capital Assets If the gain is fully excluded under Section 121, you typically don’t need to report the sale unless you received a 1099-S.
For a rental or business-use leasehold, you’ll also need Form 4797 to report the depreciation recapture portion.10Internal Revenue Service. About Form 4797 – Sales of Business Property Ordinary income and Section 1250 recapture flow through Form 4797, while any remaining long-term gain goes to Schedule D.
Estimated Tax Payments
A large gain can create a bill that regular withholding won’t cover. If you expect to owe more than $1,000 when you file, the IRS expects quarterly estimated payments rather than waiting until April. The payment is due in the quarter when the sale closes:
- Sale completed January through March: payment due April 15, 2026
- Sale completed April through May: payment due June 15, 2026
- Sale completed June through August: payment due September 15, 2026
- Sale completed September through December: payment due January 15, 2027
Underpayment penalties apply if you miss these deadlines and start accruing immediately. On a six-figure gain, waiting until the following April can cost several hundred dollars in penalties alone.
State Taxes Are on Top
Federal tax is only part of the bill. Most states tax capital gains as ordinary income, and rates vary widely. A handful of states impose no income tax at all; others tax capital gains at rates above 10%. The state where the property sits may tax the gain regardless of where you live, and your home state may tax it too (usually with a credit for taxes paid to the property’s state). Check your state’s rules before estimating your total tax, because state taxes can add meaningfully to the federal figures above.