By Harry Prabandham · Updated September 28, 2026
Tax Planning
Selling a Rental Property: How the Gain Is Taxed and Ways to Defer It
A rental sale can trigger tax on depreciation (up to 25%), capital gains, the 3.8% NIIT, and state tax. A 1031 exchange or installment sale can defer some.
Selling a Rental Property: How the Gain Is Taxed and Ways to Defer It
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How is the sale of a rental property taxed?
- Gain is the sale price, less selling costs, minus your adjusted basis: purchase price plus improvements, minus depreciation allowed or allowable.
- Gain equal to straight-line depreciation on the building is taxed at up to 25%; components depreciated faster are generally recaptured as ordinary income.
- Remaining long-term gain is taxed at 0%, 15%, or 20%, and the 3.8% net investment income tax may apply on top.
- State tax is a separate layer; California taxes capital gains as ordinary income.
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How is the sale of a rental property taxed?
- Gain is the sale price, less selling costs, minus your adjusted basis: purchase price plus improvements, minus depreciation allowed or allowable.
- Gain equal to straight-line depreciation on the building is taxed at up to 25%; components depreciated faster are generally recaptured as ordinary income.
- Remaining long-term gain is taxed at 0%, 15%, or 20%, and the 3.8% net investment income tax may apply on top.
- State tax is a separate layer; California taxes capital gains as ordinary income.
Why does depreciation matter so much at sale?
- Depreciation reduces basis whether or not you claimed it, so skipping it does not avoid the tax at sale.
- Long holding periods on a 27.5-year schedule can produce a large depreciation component of the gain.
- Cost segregation and bonus depreciation increase the portion that may be taxed at ordinary rates.
- A full taxable sale also releases suspended passive losses, which can offset part of the gain and other income.
When does the 3.8% net investment income tax apply?
- It applies to the lesser of net investment income or modified AGI above $200,000 single or $250,000 joint.
- These thresholds are not indexed, so a one-time sale can push many owners over them.
- Real estate professionals whose rental activity is a nonpassive trade or business may be able to exclude the gain from NIIT.
- Combined with the 20% top rate, the federal rate on long-term gain can reach 23.8%.
How does a 1031 exchange defer the tax?
- Reinvesting in like-kind real property held for investment or business use can defer both capital gain and depreciation-related gain.
- You have 45 days from the sale to identify replacement property and 180 days, or your return due date if earlier, to close.
- Cash or debt relief not replaced, called boot, is taxable.
- A qualified intermediary must hold the proceeds; touching the cash generally ends the exchange.
Can an installment sale or opportunity zone help?
- An installment sale spreads gain over the years payments are received, though ordinary-income recapture is taxed in the year of sale.
- Seller financing carries buyer credit risk, and very large installment notes can trigger an interest charge on the deferred tax.
- Under the original opportunity zone rules, deferred gain is recognized no later than December 31, 2026.
- The 2025 tax law made opportunity zones permanent for investments after 2026, with rolling five-year deferral and a 10% basis increase, or 30% for rural funds.
What else affects the final tax bill?
- Documented improvements raise basis and lower gain, so improvement records matter.
- Commissions and many closing costs reduce the amount realized.
- Heirs generally receive a stepped-up basis at death, which removes pre-death gain and prior depreciation from income tax.
- Converting a rental to a primary residence does not shelter prior depreciation and may limit the home-sale exclusion.
Key takeaways
- A rental sale is taxed in layers: depreciation-related gain, capital gain, NIIT, and state tax.
- Depreciation allowed or allowable reduces basis whether or not you took it.
- 1031 exchanges, installment sales, and opportunity zones each defer tax with real tradeoffs and deadlines.
- Model the after-tax proceeds with a CPA before listing the property.
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