The two-part federal calculation
When you sell a rental at a gain, the taxable gain splits into two components. (1) Depreciation recapture: the portion of your gain equal to depreciation claimed is Section 1250 gain, taxed at up to 25% federally. (2) Long-term capital gain: any remaining gain above the recapture amount is taxed at 0%, 15%, or 20% based on your taxable income. If you held the property one year or less, the entire gain is taxed at your ordinary income rate with no preferential treatment.
Additional layers: NIIT and state tax
High-income sellers may also owe the 3.8% Net Investment Income Tax on the gain (see our NIIT guide for thresholds and details). State income taxes add another layer in most states, often without a 25% federal cap equivalent on the recapture portion. In high-tax states with elevated income, the total effective rate on a rental sale gain — federal recapture plus federal capital gains plus NIIT plus state — can exceed 35%.
Strategies to reduce or defer the tax
1031 exchange: defer all gain into replacement property. Installment sale: spread the capital gain component across multiple years; recapture must be recognized in year one under Section 453(i). Capital loss harvesting: use losses from other investments to offset gains in the same year. Sell in a low-income year: retire first, sell second to hit the 0% or 15% capital gains bracket. Hold until death: heirs receive a step-up in basis, eliminating deferred recapture permanently.
Frequently asked questions
What taxes do I pay when selling a rental property?
Depreciation recapture (up to 25%), long-term capital gains (0/15/20%), possibly the 3.8% NIIT, and state income or capital gains tax. The exact amount depends on your income and hold period.
Can I avoid capital gains tax on a rental?
You can defer with a 1031 exchange, reduce with loss harvesting, or eliminate via step-up in basis at death. Outright avoidance on a profitable long-hold sale is generally not possible.
Sources
- IRS Topic No. 409 — Capital Gains and Losses
- IRS Publication 544 — Sales and Other Dispositions of Assets
- IRS Publication 946 — How to Depreciate Property
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.