Real Estate Tax Calc
Full numeric example: the three tax layers
You purchased a free-standing pharmacy under a 15-year NNN lease in January 2016 for $2,100,000. The purchase allocated $300,000 to land and $1,800,000 to building and improvements. In 2016 you commissioned a cost segregation study that reclassified $320,000 from the $1,800,000 building to shorter-lived components: $170,000 to 5-year personal property and $150,000 to 15-year land improvements. The remaining 39-year building basis was $1,480,000. You sell in November 2026 for $2,750,000 with $42,000 of selling costs.
Step 1: Accumulated depreciation through sale date
- 5-year components ($170,000): fully depreciated by 2022 under MACRS 200DB. Accumulated = $170,000
- 15-year components ($150,000): approximately 76% depreciated after ~10 years under 150DB/SL. Accumulated ≈ $114,000
- 39-year building ($1,480,000): ~10.8 years with mid-month convention ≈ 27.7% depreciated. Accumulated ≈ $410,000
- Total accumulated depreciation: $694,000
Step 2: Adjusted basis
$2,100,000 purchase price − $694,000 accumulated depreciation = $1,406,000
Step 3: Amount realized
$2,750,000 sale price − $42,000 selling costs = $2,708,000
Step 4: Total gain
$2,708,000 − $1,406,000 = $1,302,000
Step 5: Allocate gain across the three layers
- §1245 recapture (5-year + 15-year components): $170,000 + $114,000 = $284,000 ordinary income
- Unrecaptured §1250 gain (building depreciation): $410,000 at max 25%
- §1231 long-term capital gain (remaining appreciation): $1,302,000 − $284,000 − $410,000 = $608,000 at 0/15/20%
Step 6: Estimated federal tax (assuming 37% ordinary bracket, 20% LTCG rate, property held passively so 3.8% NIIT applies)
- §1245 recapture: $284,000 × (37% + 3.8%) = $284,000 × 40.8% = $115,872
- §1250 gain: $410,000 × (25% + 3.8%) = $410,000 × 28.8% = $118,080
- §1231 gain: $608,000 × (20% + 3.8%) = $608,000 × 23.8% = $144,704
- Total estimated federal tax: ~$378,656 on $1,302,000 gain (effective rate ~29.1%)
Net proceeds after tax on a $2,750,000 sale, net of $42,000 selling costs and ~$379,000 in federal tax: approximately $2,329,000. State income tax (often 5–10%) would reduce this further.
The three gain layers explained
Not all gain is the same. The IRS taxes different portions of a commercial real estate gain at different rates, and the stacking order matters.
§1245 recapture hits first and hardest. Any personal property depreciation — the 5-year and 15-year components a cost segregation study carved out of the building — is recaptured as ordinary income regardless of how long you held the property. There is no preferential rate and no holding period exception. A $300,000 block of §1245 recapture on a $2.1M building sale is taxed at your marginal ordinary income rate, up to 37% (plus NIIT).
Unrecaptured §1250 gain comes second. The straight-line depreciation taken on the building itself (the 39-year component) is not recaptured at ordinary rates — but it also does not get the favorable long-term capital gain rate. Instead, IRC §1(h)(1)(D) limits the maximum rate to 25% (plus any applicable NIIT). This is the "25% bucket" that every NNN investor accumulates year by year as the building depreciates. Ten years of 39-year straight-line on a $1.48M building basis means roughly $380,000–$410,000 sitting in this bucket by the time of sale.
§1231 long-term gain is the most tax-efficient layer. Once §1245 recapture and §1250 recapture are fully allocated, any remaining gain — the appreciation above what was depreciated — is §1231 gain, which qualifies for preferential long-term rates: 0% at lower incomes, 15% at moderate incomes, or 20% at the top bracket. Most of the appreciation in a property that has risen significantly in value ends up in this bucket.
How cost segregation multiplies §1245 recapture at sale
A cost segregation study done at acquisition is one of the most powerful first-year tax strategies for commercial real estate. But it carries a deferred cost: every dollar of 5-year or 15-year depreciation you accelerate out of the building will come back as §1245 ordinary-income recapture when you sell.
In the example above, the cost segregation study moved $320,000 from the 39-year bucket to shorter-lived categories. Without cost segregation, that $320,000 would depreciate over 39 years and generate unrecaptured §1250 gain at 25% on sale. With cost segregation, it fully depreciates in 5–15 years and generates §1245 recapture at 37–40.8%. The spread in effective rate — roughly 12–16 percentage points — is the cost of the strategy.
The net-present-value math still typically favors cost segregation. Taking a deduction now at 37% is more valuable than deferring it over 39 years, even if the deferred recapture rate would have been lower. But the benefit narrows for investors in moderate tax brackets or those who expect rates to rise. Run the numbers with your accountant before assuming cost segregation always wins.
How a 1031 exchange defers all three gain layers
A properly structured 1031 exchange defers all three layers of gain — §1245 recapture, §1250 gain, and §1231 gain — as long as the exchange meets the requirements: a qualified intermediary holds the proceeds, the replacement property is identified within 45 days, and the purchase is completed within 180 days.
The entire deferred gain carries into the replacement property's basis. If you exchange a NNN pharmacy into a NNN grocery-anchored center, the new property's tax basis is reduced by the deferred gain, which means higher future depreciation recapture and lower adjusted basis on an eventual taxable sale — but that eventual tax is deferred, sometimes indefinitely under a "swap till you drop" strategy.
Important: a 1031 exchange does not eliminate the tax; it defers it. If you hold the replacement property until death, your heirs receive a stepped-up basis under IRC §1014 and the deferred gain disappears. For estate-planning purposes, a long enough deferral through 1031 exchanges can effectively convert the tax into a wealth transfer.
Installment sale: spreading the §1231 and §1250 gain
If the buyer does not have cash and is willing to carry seller financing, an installment sale (IRC §453) lets you spread the §1231 gain and §1250 gain across the years you receive payments, reducing the year-of-sale tax spike.
The catch: §1245 recapture cannot be spread over installment payments. Under IRC §453(i), the full §1245 recapture amount is recognized as ordinary income in the year of sale, regardless of how much cash you received. In the example above, you would owe tax on $284,000 of §1245 income in 2026 even if the buyer does not pay most of the purchase price until 2027–2030.
The remaining gain — §1250 and §1231 — follows the installment schedule. You calculate a gross profit ratio (total deferred gain ÷ total contract price) and apply it to each payment received each year to determine the taxable portion. This can be a powerful cash-flow strategy for high-appreciated NNN properties where the seller does not need all the proceeds upfront.
State income tax on the sale
NNN properties spread across states are common, and each property state typically has a claim on the gain. Rental income — and capital gain from selling the property — is sourced to the state where the property is located. That means:
- You generally owe state income tax in the state where the NNN building sits, even if you live elsewhere.
- Your home state gives you a credit for taxes paid to the property state to prevent double taxation — but the credit only covers tax up to what your home state would have charged on the same income.
- Several states do not conform to federal installment sale treatment or have separate depreciation recapture rules, so the state tax calculation may differ from the federal one.
- States like California (no LTCG preference, ordinary rates up to 13.3%) can add substantially to the effective rate on the sale.
For a large NNN portfolio with buildings in multiple states, the multi-state compliance costs at sale are real and should be factored into the hold vs. sell vs. exchange decision. A 1031 exchange defers state gain taxes alongside the federal, though a few states impose their own time limits or require a "clawback" if you exchange out of state.
Planning before you sell
The best time to plan the tax consequences of a NNN sale is before you accept the offer — or better, before you even list. Key questions:
- Is 1031 exchange the right move? If you have other passive income to absorb, or if estate planning favors a step-up at death, exchanging defers the bill. If you have suspended passive losses, a taxable sale may unlock them to offset the recapture.
- Do you have passive losses to absorb the gain? Accumulated suspended passive losses from other rental properties are released in the year you sell a passive activity. They can offset §1231 gain and §1250 gain — but not §1245 recapture, which is ordinary income.
- Would an installment sale improve cash flow? If the buyer is creditworthy and you do not need all the cash, spreading the non-recapture gain across years can reduce the peak-year tax rate.
- What is the state tax exposure? States with high ordinary rates (California, New York, New Jersey) can add 8–13% to the §1245 recapture layer. That changes the math compared to a low-rate state.
- Are suspended §1231 losses in prior years? §1231 losses from prior years must be "recaptured" as ordinary income before the current year §1231 gain gets favorable treatment (the §1231 lookback rule). If you have prior-year §1231 losses, some of what looks like capital gain will be recharacterized.
Frequently asked questions
What taxes do I owe when I sell a NNN property?
Three layers: (1) §1245 recapture on cost-segregated personal property at ordinary income rates up to 37%; (2) unrecaptured §1250 gain — all accumulated building depreciation — at maximum 25%; and (3) §1231 long-term capital gain on remaining appreciation at 0/15/20%. Passive NNN investors also owe 3.8% NIIT on all three layers.
Does a NNN lease structure reduce taxes when I sell?
No. The three-layer tax applies regardless of whether the building was held under a gross lease, modified gross, or triple net lease. The tax follows the depreciation taken and the amount realized, not the lease type.
Can I use a 1031 exchange to defer taxes on a NNN sale?
Yes. A NNN investment property qualifies as like-kind real estate. All three gain layers — §1245 recapture, §1250 gain, and §1231 gain — are deferred in a properly structured exchange. The deferred gain carries into the replacement property's basis and resurfaces only on a non-exchange sale or death.
How does a cost segregation study affect the taxes when I sell?
Cost segregation accelerates deductions during holding but increases §1245 recapture at sale. Every dollar moved from the 39-year bucket to 5-year or 15-year comes back as ordinary income recapture when you sell. The NPV math usually still favors cost segregation, but the recapture is real and can be substantial.
What is unrecaptured Section 1250 gain on a NNN building?
The accumulated straight-line depreciation on the 39-year building component, taxed at a maximum federal rate of 25% rather than the preferential long-term capital gain rate. Every year of MACRS depreciation on the building increases this bucket.
Is the 3.8% Net Investment Income Tax due when I sell a NNN property?
Almost certainly yes for passive investors. NIIT applies to passive gain if your MAGI exceeds $200,000 (single) or $250,000 (MFJ). All three gain layers are net investment income unless the property was held in a non-passive trade or business in which you materially participated.
Can I use an installment sale to spread the tax on a NNN sale?
Partially. §1245 recapture must be recognized in full in the year of sale and cannot be spread. The remaining §1231 gain and §1250 gain can follow the installment schedule proportionately, spreading the non-recapture tax over the payment years.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.