Selling a Rental Property: Capital Gains, Depreciation, and 1031s

Selling a rental property can trigger up to three federal taxes: long-term capital gains tax on your profit, a 25% tax on the depreciation you claimed (or could have claimed) during ownership, and a 3.8% Net Investment Income Tax if your income is high enough. Most sellers also owe state income tax on the gain, ranging from nothing in states without an income tax to more than 13% in the highest-tax states. The tax implications of selling a rental property depend on how long you owned it, how much it appreciated, how much depreciation accumulated, and your total income for the year. Several strategies can reduce or defer the bill.

Capital Gains Tax on Your Profit

Profit from a rental sale is a capital gain. If you held the property for one year or less, the gain is taxed as ordinary income at your regular rate. Hold it longer than a year and the long-term capital gains rates apply: 0%, 15%, or 20%, depending on your total taxable income.¹

For 2026, single filers pay 0% on taxable income up to $49,450, 15% from $49,451 to $545,500, and 20% above $545,500. Married couples filing jointly hit the 20% rate above $613,700. The brackets adjust for inflation each year, so confirm the numbers for your filing year.

Figuring Your Adjusted Basis

The taxable gain is not simply sale price minus purchase price. Your adjusted basis starts with what you originally paid, plus acquisition costs like title insurance, transfer taxes, and recording fees. Add the cost of every capital improvement you made over the years. Then subtract all depreciation taken or allowed. Your gain is the difference between net sale proceeds (after commissions and closing costs) and this adjusted basis.

Every dollar you can legitimately add to basis is a dollar of gain that goes untaxed, so this piece deserves real attention. Commissions, legal fees, and transfer taxes at closing all reduce the reportable gain.

Improvements Versus Repairs

Money spent on the property splits into two categories with very different tax treatment. Repairs keep the property in its current condition: patching a roof leak, repainting, fixing a broken appliance. These were deductible as expenses in the year paid and do not increase basis. Improvements add value, extend the property’s useful life, or adapt it to new use. The IRS groups improvements into betterments (expanding square footage, upgrading major systems), restorations (replacing a substantial structural component), and adaptations (converting a garage into a rental unit).²

Improvements get capitalized into basis and depreciated over time. At sale, they raise your basis and reduce taxable gain. A new roof, HVAC replacement, kitchen remodel, added bathroom, any qualifying project counts. Sellers who skip this reconstruction often overpay by tens of thousands because their basis looks artificially low.

The 25% Tax on Prior Depreciation

This is the tax that catches many sellers off guard. While you owned the rental, you were entitled to deduct depreciation each year, spreading the building’s cost over 27.5 years using the straight-line method.³ At sale, the IRS wants that benefit back. Total depreciation claimed over your ownership is taxed at a maximum rate of 25%, on top of the capital gains tax on the rest of your profit.⁴

The tax code calls this “unrecaptured Section 1250 gain.” It is a capital gains sub-rate, not ordinary income, but it is higher than the 15% most sellers pay on the rest of their long-term gain. Recapture is calculated first, and only the remaining profit falls into your regular long-term rate.

Allowed or Allowable

Recapture applies to the depreciation you were permitted to deduct, not just what you actually claimed. If you owned a rental for ten years and never took the depreciation deduction, the IRS still reduces your basis by the full depreciation you could have taken. Publication 551 is blunt: if you did not take the deduction, reduce your basis by the full amount you could have taken under your depreciation method.⁵

Skipping depreciation during ownership saves you nothing at sale. It makes things worse, because you lost the annual deductions without changing the recapture. If you have not been claiming depreciation, talk to a tax professional about amending past returns before you sell.

A Worked Example

Say you bought a rental for $300,000, with $50,000 allocated to non-depreciable land, and sell ten years later for $400,000. Over those ten years, you were allowed roughly $90,909 in depreciation on the $250,000 building value ($250,000 ÷ 27.5 × 10). Your adjusted basis is $209,091, and your total gain is $190,909. The first $90,909 is taxed at up to 25% (up to $22,727). The remaining $100,000 is taxed at your long-term capital gains rate, likely 15% ($15,000). Total federal tax on the sale: roughly $37,727, before any surtax.

The 3.8% Net Investment Income Tax

Higher-income sellers face an additional 3.8% surtax on investment income. It applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds a threshold: $200,000 for single filers, $250,000 for joint filers.⁶ These thresholds are not indexed for inflation, so more taxpayers cross them each year.

Your rental sale gain, including the recapture portion, counts as net investment income. So do dividends, interest, and other rental income for the year. You calculate the tax on Form 8960.⁷ For a seller in the 15% capital gains bracket who also triggers the NIIT, the effective federal rate on the non-recapture portion climbs to 18.8%, and the recapture portion reaches 28.8%. State tax comes on top of that.

Suspended Passive Losses You May Have Forgotten

This is the piece of good news most sellers overlook. If you had rental losses in prior years that you could not deduct because of the passive activity loss rules, those “suspended” losses did not disappear. They carry forward indefinitely. When you sell the entire property in a fully taxable transaction, every dollar of accumulated suspended losses becomes deductible against the gain and your other income.⁸

Three conditions apply. You must dispose of your entire interest in the property. The sale must be a fully taxable event; a 1031 exchange does not qualify because no gain is recognized (except to the extent of boot). And the buyer cannot be a related party such as a spouse, sibling, parent, child, or an entity where you own more than 50%.⁸

Pull your past returns and add up the suspended losses reported on Form 8582 before you finalize a sale strategy. A seller with $60,000 in accumulated suspended losses selling at a $190,000 gain is taxed on only $130,000 of net gain.

Deferring the Tax With a 1031 Exchange

A like-kind exchange under Section 1031 lets you roll the proceeds into another investment property and defer both the capital gains tax and the depreciation recapture. No gain is recognized as long as the replacement property is of equal or greater value and you follow the rules precisely.⁹

You cannot touch the sale proceeds at any point. A Qualified Intermediary holds the funds between the sale of the old property and the purchase of the new one.

The Two Deadlines

Two firm deadlines run from the day you close on the sale:

Within 45 calendar days, you must identify potential replacement properties in writing to your intermediary. Miss this deadline by one day and the entire exchange fails.
Within 180 days of the original sale, or by the due date (with extensions) of your tax return for that year, whichever comes first, you must close on the replacement.⁹

The tax return nuance trips up sellers who close late in the year. Sell in November and your return is due April 15, giving you fewer than 180 days unless you file an extension.

Most sellers identify replacements under the three-property rule: up to three potential properties regardless of value, then purchase one or more. If you want to identify more than three, the combined fair market value of everything identified cannot exceed 200% of the relinquished property’s sale price.

Boot

If you receive cash back at closing, or the replacement property has a lower mortgage balance and reduces your debt, the difference is “boot” and is immediately taxable. The exchange still defers tax on the non-boot portion, but you owe capital gains tax on whatever you pocket or whatever debt relief you receive.

Spreading the Gain With an Installment Sale

Seller financing lets you spread the taxable gain across multiple years. When you carry a note for the buyer and receive payments over time, the IRS treats it as an installment sale. You report a proportional share of the gain in each year you receive a payment, using Form 6252.¹⁰

One major catch: depreciation recapture cannot be spread out. You report the full recapture amount as income in the year of the sale, regardless of how little cash you actually received that year.¹¹ If the property has $90,000 in accumulated depreciation and the buyer makes only a $50,000 down payment, you owe tax on the full $90,000 recapture in year one. The remaining capital gain is recognized proportionally as installment payments come in.

You file Form 6252 every year until the final payment, even in years with no payment. Related-party sales get extra scrutiny: if the buyer is a family member or controlled entity and resells within two years, the IRS may accelerate your remaining gain into that year.

If You Inherited the Property

Inherited rentals get much friendlier tax treatment. The property’s basis resets to fair market value on the date of the original owner’s death, wiping out appreciation and depreciation that accumulated during their lifetime.¹² You owe capital gains tax only on appreciation after you inherited, not decades of growth under the prior owner.

The holding period is favorable too. Even if you sell within months of inheriting, the gain qualifies as long-term and is taxed at the lower long-term rates.¹³

Depreciation starts fresh. You begin a new 27.5-year schedule based on the stepped-up building value (minus land), regardless of where the prior owner was in their schedule. If you keep renting the property, only depreciation you take from that point forward is subject to recapture when you sell.

If the Rental Was Once Your Home

When you sell a property that served as both your home and a rental at different times, part of the gain may qualify for the Section 121 exclusion. That exclusion shields up to $250,000 of gain from tax, or $500,000 for married joint filers, if you owned and lived in the home for at least two of the five years before the sale.¹⁴

The exclusion does not cover everything. Depreciation recapture remains fully taxable at the 25% rate no matter how long you lived there. If you used the property as a rental before moving in, the IRS allocates gain between “qualified use” (time as your residence) and “nonqualified use” (time as a rental) based on the ratio of each period to total ownership. Only qualified-use gain is eligible for the exclusion. Rental periods before January 1, 2009, are excluded from the nonqualified-use calculation, and rental use after your last period of personal residence also does not count against you.¹⁴

Paying the Tax on Time

A rental sale can generate a tax bill large enough to trigger underpayment penalties if you do not plan ahead. The IRS expects taxes throughout the year, not just at filing. If you expect to owe $1,000 or more after withholding and credits, you generally need to make estimated tax payments.¹⁵

To avoid penalties, your total payments for the year must equal the lesser of 90% of your current-year tax liability or 100% of last year’s tax (110% if your prior-year AGI exceeded $150,000). That second option is the safe harbor most sellers rely on: pay at least 100% or 110% of last year’s total tax through withholding and estimated payments, and you owe no penalty regardless of how large the sale gain is.¹⁵

Quarterly estimated payments for 2026 are due April 15, June 15, September 15, and January 15, 2027. If the sale closes late in the year, the annualized income installment method on Schedule AI of Form 2210 can reduce or eliminate the penalty by showing that the income arrived in a later quarter.¹⁶ Without it, the IRS assumes income was earned evenly and charges penalties accordingly.

Reporting the Sale

The sale is reported across several forms. Form 4797 is the starting point for rental property, where you report the sale details and calculate any depreciation recapture. If total gain exceeds the recapture amount, the excess capital gain flows to Form 8949 and then Schedule D.¹⁷ Sellers who trigger the NIIT also file Form 8960, and those using the installment method add Form 6252 every year until the final payment.

Gather your original closing statement, records of every capital improvement, depreciation schedules from past returns, and the final settlement from the sale. Missing documentation is where most reporting errors start, especially for properties held a decade or longer where records have scattered.

1
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
2
Internal Revenue Service. Publication 527, Residential Rental Property
3
Internal Revenue Service. Depreciation and Recapture
4
Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed – Section: Unrecaptured Section 1250 Gain
5
Internal Revenue Service. Publication 551, Basis of Assets
6
Internal Revenue Service. Instructions for Form 8960
7
Internal Revenue Service. About Form 8960, Net Investment Income Tax
8
Office of the Law Revision Counsel. 26 USC 469 – Passive Activity Losses and Credits Limited
9
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
10
Internal Revenue Service. Form 6252, Installment Sale Income
11
Internal Revenue Service. Topic No. 705, Installment Sales
12
Office of the Law Revision Counsel. 26 USC 1014 – Basis of Property Acquired From a Decedent
13
Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property
14
Office of the Law Revision Counsel. 26 USC 121 – Exclusion of Gain From Sale of Principal Residence
15
Internal Revenue Service. Estimated Tax for Individuals, 2026 Form 1040-ES
16
Internal Revenue Service. Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts
17
Internal Revenue Service. Instructions for Form 4797, Sales of Business Property