Years of depreciation deductions lowered your taxes as a landlord. When you sell, many of those deductions come back. Here’s how the tax on a rental sale really works.
Most rental owners know that selling a property they’ve held for years means capital gains tax. What many don’t realize until the closing statement arrives is that there’s a second tax layered on top, and sometimes a third and fourth.
Why depreciation comes back
Every year you own a rental, the tax code lets you deduct part of the building’s cost as depreciation. That deduction lowers your taxable rental income. But it also lowers your cost basis in the property. When you sell, the part of your gain created by those deductions is taxed separately.
The gain from depreciation you claimed can be taxed at up to 25%, and a 3.8% investment income tax may apply on top.
IRS
The IRS calls it unrecaptured Section 1250 gain, and it applies whether or not you actually claimed the depreciation you were entitled to.1 If your ordinary tax rate is below 25%, that portion is taxed at your lower rate instead.2
The layers of tax on a rental sale
What you may owe when you sell A long-held California rental can face all four of these. | |
Depreciation recapture | Up to 25% federal The part of the gain equal to the depreciation you claimed, or could have claimed, over the years. |
Capital gains | 0%, 15%, or 20% federal The rest of the gain, from true appreciation, at long-term capital gains rates. |
Net investment income tax | 3.8% federal Applies to higher-income sellers on the taxable gain. |
California income tax | Taxed as ordinary income California doesn’t have a lower capital gains rate, so the state takes its share at your regular state rate. |
General information only. Your CPA should calculate the actual tax on any sale. | |
Ways to soften the bill
– Know your number first. Ask your CPA to estimate your adjusted basis and the tax on a sale before you list. It changes the conversation about price and timing.
– Spread it out. An installment sale, where the buyer pays over time, can spread the gain across several tax years.
– Pair it with giving. A charitable remainder trust can sell the property without an immediate tax bill and pay you income for life.
– Consider holding. Heirs generally receive a stepped-up basis at death, which can wipe out both the built-up gain and the depreciation recapture.
Where I come in
Selling a rental is rarely just a real estate decision. I help clients model the after-tax proceeds of each option with their CPA, then decide whether to sell, exchange, or hold based on what the money needs to do next: fund retirement, diversify, or pass to the next generation.
Thinking about selling a rental? Let’s find out what you’d actually walk away with.
About the author Matthew Holbrook, CFP® Coastline Wealth Advisory of LPL Financial | Newport Beach Matt has spent over 2 decades helping families, business owners, and professionals coordinate their investments, taxes, and estate plans. He works directly with each client and their CPA and attorney, so every decision pulls in the same direction. |
Sources
1. IRS, Rental property sale: exclusion and depreciation (FAQ).
2. Johnson, Miller & Co., Depreciation Recapture Tax Rate: What Real Estate Investors Need to Know.
Important Disclosures
LPL Tracking #1187509 This material is for general information only and is not intended to provide specific advice or recommendations for any individual. LPL Financial and its representatives do not provide tax or legal advice. Please consult your tax advisor or attorney regarding your specific situation. Matthew Holbrook is a registered representative with, and securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/ SIPC.