Capital Gains Tax on Rental Property: Rates, Recapture, and Deferral

The capital gains tax on a rental property sale is rarely a single number. Federal law stacks three potential layers on the profit: long-term capital gains rates of 0%, 15%, or 20% on the appreciation; a depreciation recapture tax of up to 25% on every deduction you claimed during ownership; and, for higher earners, an additional 3.8% net investment income surtax. State income tax typically sits on top of all of that. Several strategies can shrink or defer the bill, but you need to know what you’re up against first.

What You’re Actually Taxed On

Your taxable gain is the sale price, minus selling expenses, minus your adjusted basis. Basis starts with the purchase price and certain closing costs like title insurance and recording fees, then goes up for capital improvements (a new roof, HVAC replacement, an added deck) and down for the depreciation you claimed or were entitled to claim each year.¹²

Residential rental buildings depreciate on a straight line over 27.5 years. Each year of depreciation lowered your rental income at the time, but it also lowered your basis, which enlarges the gain you owe tax on now.

Inherited a rental? Your basis isn’t what the prior owner paid. Inherited property receives a stepped-up basis equal to fair market value on the date of the prior owner’s death, and you automatically qualify for long-term capital gains rates no matter how briefly you’ve held it.³ Appreciation during the decedent’s lifetime is wiped clean for tax purposes.

Long-Term vs. Short-Term Rates

Hold the property for a year or less and the profit is a short-term capital gain, taxed at your ordinary income rate. For 2026 that runs from 10% to 37%, the same rates that apply to your wages.⁴ There is no tax advantage to selling quickly.

Hold for more than a year and long-term rates apply. For 2026:⁵

0% on taxable income up to $49,450 (single), $98,900 (married filing jointly), or $66,200 (head of household).
15% above those thresholds up to $545,500 (single), $613,700 (married filing jointly), or $579,600 (head of household).
20% above the 15% ceiling.

Most rental sellers land in the 15% bracket. The 0% rate is theoretically available, but a rental sale large enough to matter usually pushes total income well past the lower thresholds on its own.

Depreciation Recapture

This is the layer that catches sellers off guard. Every year of depreciation you deducted gets recaptured at sale and taxed as a separate category of gain, even if the property lost market value overall. Recapture targets the tax benefits you already received, not the property’s performance.

For the building, recaptured depreciation (technically “unrecaptured Section 1250 gain”) is taxed at a maximum federal rate of 25%.⁶ If your ordinary bracket is lower, you pay that lower rate instead.

Personal property inside the rental (appliances, carpeting, light fixtures) is treated more harshly. Depreciation on those items is recaptured at your full ordinary income rate with no 25% cap, meaning it can reach 37%.⁷ Track the total depreciation claimed during ownership; you’ll need it for your return.

The 3.8% Net Investment Income Tax

Higher earners owe an extra 3.8% on rental sale gains. The Net Investment Income Tax applies once modified adjusted gross income exceeds $200,000 for single filers, $250,000 for married filing jointly, or $125,000 for married filing separately.⁸ Those thresholds do not adjust for inflation, so more sellers cross them each year.

The surtax hits the smaller of your net investment income or the amount by which your modified AGI exceeds the threshold. Both the capital gain and any depreciation recapture count as investment income.⁹ Related expenses, including allocable state income taxes and investment advisory fees, can reduce that figure.

Stacked together, a top-bracket investor can face an effective federal rate of 23.8% on the capital gain portion and 28.8% on recaptured building depreciation. A property held a decade with meaningful depreciation can generate a six-figure federal bill in one year.

Ways to Reduce or Defer the Tax

Section 1031 Like-Kind Exchange

A 1031 exchange defers the entire capital gain and depreciation recapture bill by rolling the proceeds into another investment property.¹⁰ The mechanics are strict. A Qualified Intermediary must hold the sale proceeds; if you ever touch the money, the deferral fails. You have 45 days from the sale to identify replacement property in writing, and 180 days from the sale (or the due date of your return, whichever is earlier) to close.

The identification rule most investors use is the three-property rule: name up to three potential replacements of any value. If you list more than three, their combined fair market value cannot exceed 200% of what you sold.

If the replacement costs less than what you sold, or carries less mortgage debt, the difference is “boot” and is taxed in the year of the exchange. The rest of the gain still defers. Boot on a property held more than a year is taxed at long-term capital gains rates.

Suspended Passive Losses

Rental losses you couldn’t deduct in earlier years because of the passive activity rules do not vanish. They accumulate and are released in full when you dispose of your entire interest in the activity in a fully taxable transaction to an unrelated buyer.¹¹¹² Every dollar of released losses offsets gain dollar for dollar. A 1031 exchange does not trigger the release, because the gain is not recognized. An installment sale releases the losses proportionally with each payment rather than all at once.

Moving In Before Selling

Convert the rental to your primary residence, live there for at least two of the five years before selling, and up to $250,000 of gain ($500,000 for married joint filers) can be excluded under Section 121.¹³

Two catches limit how much this actually helps a former rental. First, the gain must be allocated between qualified use (living there) and nonqualified use (renting it out after January 1, 2009); only the qualified-use share is eligible for the exclusion. Second, the exclusion does not shield depreciation recapture.¹⁴ Even if the entire capital gain fits under the exclusion cap, the 25% recapture on prior depreciation is still owed.

Installment Sales

Spreading payments across years spreads the taxable gain. Under Section 453, any sale with at least one payment arriving after the end of the year of sale qualifies for installment treatment.¹⁵ Each payment carries the same gross profit percentage; if gross profit is 40% of the contract price, 40% of each payment is gain and the rest is return of basis. Spreading gain across years can keep you in a lower capital gains bracket and below the NIIT threshold in each year.

The trade-offs: you take on the buyer’s credit risk and lose access to the full proceeds for reinvestment. Installment treatment also does not defer depreciation recapture. The IRS generally requires you to recognize all recapture in the year of sale, regardless of when the cash arrives.

State Taxes on the Sale

Federal is not the whole bill. Most states tax capital gains from property sales as ordinary income, and rates range from zero in states with no income tax to over 13% in the highest. A few states treat capital gains more favorably, but most do not. Some jurisdictions also charge transfer or documentary stamp taxes at closing, usually modest relative to income tax. Combined federal and state rates above 30% of the gain are common for higher-income sellers.

How the Sale Gets Reported

Several IRS forms work together, and the IRS cross-checks them against closing documents filed by the title company.

Form 4797 calculates depreciation recapture. Part III sorts out what portion of the gain is taxed as ordinary income; the balance flows to Form 8949.¹⁶
Form 8949 and Schedule D report the capital gain portion.
Form 8824 reports a Section 1031 exchange, calculating the deferred gain and the basis of the replacement property.¹⁷
Form 6252 tracks an installment sale year by year.

All of these are filed with the return for the year of sale. On a 1031 exchange, the 180-day closing window can be shortened if your return’s due date (including extensions) arrives first, so filing an extension is routine on exchange transactions and preserves the full 180 days.¹⁰

1
Office of the Law Revision Counsel. 26 USC 1011 – Adjusted Basis for Determining Gain or Loss
2
Office of the Law Revision Counsel. 26 USC 168 – Accelerated Cost Recovery System
3
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired from a Decedent
4
Office of the Law Revision Counsel. 26 USC 1222 – Other Terms Relating to Capital Gains and Losses
5
Tax Foundation. 2026 Tax Brackets and Federal Income Tax Rates
6
Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed
7
Office of the Law Revision Counsel. 26 USC 1250 – Gain from Dispositions of Certain Depreciable Realty
8
Internal Revenue Service. Topic No. 559, Net Investment Income Tax
9
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
10
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Property Held for Productive Use or Investment
11
Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits
12
Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules
13
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain from Sale of Principal Residence
14
eCFR. 26 CFR 1.121-1 – Exclusion of Gain from Sale or Exchange of a Principal Residence
15
Office of the Law Revision Counsel. 26 USC 453 – Installment Method
16
Internal Revenue Service. Instructions for Form 4797
17
Internal Revenue Service. Instructions for Form 8824