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Taxes When You Sell a Rental Property

Most of the tax you defer while you own a rental comes due when you sell. A sale of a rental you have held for more than a year can involve four separate federal layers: depreciation recapture, long-term capital gains tax, the 3.8% net investment income tax, and state income tax. Knowing how each one works is what lets you plan the timing, the structure, or the decision to sell at all.

1. Depreciation recapture (unrecaptured section 1250 gain)

Every dollar of depreciation lowers your basis, so it shows up again as gain when you sell. For a residential rental building depreciated straight-line, that part of the gain is “unrecaptured section 1250 gain”. Under IRC section 1(h)(1)(E) it is taxed at a maximum of 25% (IRS Topic 409). It is not a flat 25%: the portion that, stacked on your other income, falls in the 10%, 12%, 22% or 24% brackets is taxed at those ordinary rates, and only the portion that would reach the 32% bracket or higher is capped at 25%. The IRS Schedule D Tax Worksheet does this calculation line by line.

Two details matter. Recapture applies to depreciation “allowed or allowable”, so you owe it even on depreciation you forgot to claim (IRS Publication 544). And items with shorter lives, such as appliances, carpet, or the 5-year and 15-year components from a cost segregation study, are section 1245 property: their gain is ordinary income up to the depreciation taken.

2. Long-term capital gains brackets for 2026

Gain above the recapture amount is long-term capital gain if you held the property more than one year. The rates are 0%, 15% and 20%, and the brackets are based on your total taxable income, with the gain stacked on top of your other income. The 2026 thresholds from Rev. Proc. 2025-32:

Because a large gain pushes itself up through the brackets, the “20% capital gains rate” quoted in many articles is often wrong for a small landlord. A couple with modest other income may pay 15% on most of the gain and ordinary rates on the recapture. Spreading a sale across tax years, or selling in a lower-income year such as early retirement, can change the result.

3. The 3.8% net investment income tax

IRC section 1411 adds 3.8% on the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $250,000 (married filing jointly), $200,000 (single or head of household) or $125,000 (married filing separately). The IRS NIIT page lists rental income and capital gains as investment income, and the thresholds are not indexed for inflation, so more sellers hit them every year. A one-time sale can push an otherwise moderate income over the line. Real estate professionals whose rentals are a trade or business may be outside the tax (see the Form 8960 instructions).

4. State income tax

Most states tax capital gains as ordinary income, and a few have no income tax. Your state may also tax the gain if the property is located there even if you live elsewhere. Check your state revenue department’s rules.

Ways to Reduce or Defer the Tax at Sale

1031 like-kind exchange

Under IRC section 1031 you can defer both the capital gain and the recapture by reinvesting in other real property held for business or investment. A qualified intermediary must hold the proceeds; you have 45 days from the sale to identify replacement property in writing and must close by the earlier of 180 days or your return due date, including extensions (IRS Form 8824 instructions). Cash you keep and debt you don’t replace (“boot”) is taxable. The deferred gain carries into the new property’s basis. Suspended passive losses generally stay suspended because an exchange is not a fully taxable disposition. See the 1031 exchange calculator for identification rules and boot examples.

Installment sale (seller financing)

If you carry a note for the buyer, capital gain is generally reported as you receive principal. But depreciation recapture that is ordinary income under sections 1245 or 1250 must be reported in full in the year of sale, whether or not you receive cash that year (IRS Publication 537). Unrecaptured section 1250 gain is generally reported first as payments come in. For a sale over $150,000, interest is charged on the deferred tax if your outstanding installment notes from the year exceed $5 million at year end. An installment sale spreads the tax and can keep you in lower brackets; it also makes you the lender, with the default risk that comes with it.

Stepped-up basis at death

Property inherited from a decedent generally takes a basis equal to its fair market value at the date of death (IRC section 1014; IRS Publication 551). The appreciation and the depreciation recapture built up during your lifetime are not income-taxed to your heirs, and that includes gain deferred through earlier 1031 exchanges. The federal estate tax basic exclusion is $15,000,000 for 2026 deaths. Unused passive losses are allowed on the final return only to the extent they exceed the basis step-up (IRS Publication 925). Holding is a real strategy for owners who don’t need the money; it is a poor one if it leaves you managing property you no longer want.

The section 121 exclusion for a former home

If the rental used to be your main home, you may be able to exclude up to $250,000 of gain ($500,000 for most married couples filing jointly) under IRC section 121. You must have owned and used it as your main home for at least 24 months in the 5 years before the sale (IRS Publication 523). Three rules matter for converted homes:

• Timing. Two years of use out of five means a former home generally has to be sold within about three years of moving out.
• Depreciation is never excluded. Depreciation claimed after May 6, 1997 is taxed as unrecaptured section 1250 gain even when the rest of the gain is excluded.
• Nonqualified use. Gain is prorated out of the exclusion for periods after 2008 when the property was not your main home, such as renting it before you moved in. Rental time after you move out, within the 5-year window, is not nonqualified use.

A home acquired in a 1031 exchange must be held for 5 years before the exclusion can apply. Where a sale qualifies for both section 121 and section 1031, the exclusion is applied first.

Worked Example: Selling a Rental in 2026

Hypothetical: a married couple filing jointly bought a rental house for $300,000 and have claimed $60,000 of depreciation. They sell it in 2026 for $500,000 and pay $30,000 in selling costs. Their other taxable income, after the $32,200 standard deduction, is $80,000.

Step 1: stack the recapture. Ordinary income fills the brackets to $80,000. The $60,000 of recapture sits from $80,000 to $140,000, all below the top of the 24% bracket ($403,550), so it is taxed at ordinary rates: $20,800 at 12% (to $100,800) = $2,496, plus $39,200 at 22% = $8,624. Recapture tax: $11,120, an average of 18.5%, not 25%.

Step 2: stack the capital gain. The $170,000 sits from $140,000 to $310,000. That is entirely above the $98,900 zero-rate ceiling and below $613,700, so it is all taxed at 15%: $25,500.

Step 3: NIIT. Their modified adjusted gross income is about $342,200 (taxable income of $310,000 plus the $32,200 standard deduction). That is $92,200 over the $250,000 threshold, less than the $230,000 of investment income, so NIIT is $92,200 × 3.8% = $3,504.

Federal total: about $40,124, or roughly 17.4% of the gain, before state tax. A flat “20% gain plus 25% recapture” estimate would have put their income tax at $49,000 before NIIT, against the actual $36,620, an overstatement of $12,380. For a couple with $400,000 of other taxable income the same sale would cost about $50,020 federal, because most of the recapture hits the 25% cap, part of the gain reaches 20%, and NIIT applies to the full $230,000. The keep or sell rental property calculator stacks these layers for your filing status and compares the result with keeping, exchanging, seller financing and holding for heirs.

Checklist: What to Bring Your CPA Before You Sell

Book the conversation before you list, not after you close. Most of the options above (an exchange, an installment note, the timing of the sale) have to be set up before the sale closes.

• Purchase closing statement (settlement statement or Closing Disclosure) and the original land/building allocation
• Depreciation schedules from every year’s return (Form 4562 and the preparer’s asset detail)
• Invoices for every capital improvement, with dates placed in service
• Any cost segregation study and the list of 5-year and 15-year assets
• Suspended passive loss carryforwards (Form 8582 worksheets) and any QBI loss carryforwards
• If the property came from a 1031 exchange: the prior Form 8824 and the carryover basis
• If it was ever your home: move-in and move-out dates and proof of residence for the section 121 tests
• The expected sale price, selling costs and mortgage payoff
• An estimate of your other income for the year of sale and the following year
• Your plans for the proceeds: reinvest, pay off debt, retire, or hold for heirs

Keep property records until the period of limitations expires for the year you dispose of the property in a taxable sale (IRS Publication 583). For a property received in an exchange, that means keeping the records for the old property too.

Common Tax Mistakes to Avoid

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