Capital Gains Tax on Rental Property

Capital gains tax on rental property is the federal tax on the gain when you sell a rental you held for investment. IRS Topic 409 states the core test. You have a capital gain if you sell the asset for more than your adjusted basis. You have a capital loss if you sell it for less. The gain is not the cash wired to you at the closing table. The gain is the amount realized minus adjusted basis.

These figures are an illustration. They are not a tax opinion, a rate quote, or a prediction of what you will owe. An inquiry is not an approval. Your preparer applies the return you actually file.

Capital Gains Tax on Rental Property When You Sell

Publication 544 defines the two sides. The amount you realize is the money you receive, plus the fair market value of any property or services you receive, plus liabilities the buyer assumes and liabilities the property is subject to, such as a mortgage. Selling expenses come off that total. Adjusted basis starts at original cost or other basis, increases by improvements with a useful life of more than one year, and decreases by depreciation and casualty losses.

Here is a rental sale built on those rules. The records show this adjusted basis:

• Cost basis of the purchase, including the closing costs that belong in basis: $350,000
• Capital improvement, a roof, added later: $14,000
• Depreciation already taken on the building: $60,000
• Depreciation already taken on the roof: $2,000
• Adjusted basis: $302,000

The contract price is $500,000. Commissions and other selling expenses are $30,000. Amount realized is $470,000. Gain is $470,000 minus $302,000, or $168,000.

Line	Amount
Contract price	$500,000
Less selling expenses	$30,000
Amount realized	$470,000
Less adjusted basis	$302,000
Gain	$168,000

The mortgage payoff in this illustration is $210,000. Cash to the seller is $500,000 minus $30,000 minus $210,000, or $260,000. The gain is $168,000. The check is larger than the gain here because the payoff is a use of the price, and the basis is still $302,000. Publication 544 includes debt relief in the amount realized. Paying the loan off from the price at closing is the same economic idea: the contract price already contains the dollars that go to the lender. Do not subtract the payoff a second time, and do not report the wire amount as the gain.

If the buyer assumes the loan, you add that assumed balance to the cash you receive, then subtract selling expenses. You still compare the result with adjusted basis. The settlement statement is the source. The “cash to seller” line is the source for your bank account.

How the $350,000 cost basis was built, and which closing costs belong in it, is covered in rental property cost basis. Depreciation reduced that basis. The straight-line deduction that created the $60,000 and the $2,000 is covered in how depreciation works on a rental.

How Long You Held the Rental

Topic 409 splits gains into long-term and short-term. If you hold the asset for more than one year before you dispose of it, the gain or loss is long-term. If you hold it one year or less, the gain or loss is short-term. You generally count from the day after you acquired the asset through the day you disposed of it. Exceptions for property acquired by gift, from a decedent, or in other special cases are in Publication 544.

Net short-term capital gain is taxed as ordinary income. A net capital gain, which Topic 409 defines as net long-term capital gain minus net short-term capital loss, can be taxed at a lower rate than ordinary income. Topic 409 says some or all net capital gain may be taxed at 0 percent. For most individuals, the rate on most net capital gain is no higher than 15 percent. A 20 percent rate applies to the extent taxable income exceeds the thresholds on that page. Those thresholds move with the tax year. Read the page for the brackets that match the return you are filing. This article does not freeze them.

A rental sale often has one more rate. Topic 409 says the portion of any unrecaptured section 1250 gain from selling section 1250 real property is taxed at a maximum 25 percent rate. That portion is tied to depreciation taken on the building. The worksheet for it is on the depreciation recapture page. On a long-term sale, part of the $168,000 can face that maximum, and the rest follows the 0, 15, and 20 percent schedule. Do not multiply the whole gain by 15 percent and call it the tax.

Topic 409 also points to the net investment income tax for individuals with significant investment income. See Topic 559. State tax, if your state taxes the gain, is a separate computation. This page is the federal gain.

Adjusted Basis Is the Whole History

You cannot measure the gain from the original purchase price alone if you improved the property or depreciated it. Publication 544 is direct: improvements increase basis, and depreciation decreases it. The decrease includes depreciation you were allowed to claim even if a prior return skipped it. Selling a rental and then discovering the depreciation schedule was thin does not restore the basis you should have reduced.

Keep the land and the building straight when you read the file. Land is part of cost basis. The depreciation you subtract was taken on the building and on capital improvements, not on the land. The adjusted basis of the whole property is what you compare with the amount realized. How the original split was made sits on the depreciation page.

Property you inherited, or received as a gift, can start from a basis other than a price you paid. Publication 544 sends that case to Publication 551. Whether to keep an inherited rental is the practical version of that starting point. Use it before you drop a purchase-price formula onto a property you never bought.

Personal-use history changes the computation again. A house that was a home and later a rental follows the conversion rules, including the basis you were allowed to depreciate. This page is a rental held for investment and then sold. A property with a stretch of personal use needs the conversion records before anyone quotes a gain.

Cash the Gain Leaves Out

The $168,000 is the federal gain on the sale. Cash you took as distributions along the way, the principal you paid down, and the taxes you already paid all sit outside this one subtraction. The gain is one input to a hold-or-sell choice. When to sell a rental property is the hold-or-sell question. This page only measures the federal gain if you do sell in a taxable sale.

A large gain can require estimated tax payments. Topic 409 points to Publication 505 for that. The sale also gets reported. Topic 409 says most sales are reported on Form 8949 and summarized on Schedule D. Installment reporting, if you take a note from the buyer, is a different publication and a different calendar of tax. Get that advice before you agree to carry the note, because the note changes both the cash and the timing.

If the amount realized is below adjusted basis, Topic 409 calls the difference a capital loss. Capital losses offset capital gains. When losses exceed gains, Topic 409 limits the deduction against other income to the lesser of $3,000 ($1,500 if married filing separately) or your total net loss, with the unused loss carried forward. A rental loss still has to be a real loss under the amount-realized test. A low wire amount caused by a large loan payoff can coexist with a gain.

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Frequently Asked Questions

Is the cash I receive at closing the taxable gain?

The taxable gain is the amount realized minus adjusted basis. Amount realized starts from the contract price, includes debt the buyer takes on, and subtracts selling expenses. The mortgage payoff reduces the check you deposit. It does not reduce the gain a second time if the contract price already included those dollars.

How does depreciation change capital gains tax on a rental property?

Depreciation you were allowed reduces adjusted basis. A lower basis raises the gain on a later sale. Topic 409 taxes the unrecaptured section 1250 portion of that gain at a maximum 25 percent rate. The rest of a long-term gain follows the 0, 15, and 20 percent rules on that page. The recapture worksheet is a separate article.

What if I sell the rental at a loss?

Compare adjusted basis with the amount realized. If basis is higher, Publication 544 calls the difference a loss. Topic 409 then limits how much net capital loss you can deduct against other income in a year, and it allows a carryforward of the unused amount. Confirm the loss with the settlement statement and the depreciation schedule before you treat a thin check as a loss.

Do I report a rental sale on Schedule E?

Schedule E is where many owners report rental income and expenses during the hold. Topic 409 says you generally report the sale on Form 8949 and Schedule D. Depreciation for the final period of ownership still belongs on the depreciation forms for that year. The sale itself is a disposition, reported with the gain or loss computation.

Does a refinance before the sale change the gain?

A refinance changes the loan balance and can put cash in your account earlier. The gain on a later taxable sale still uses amount realized and adjusted basis. Cash you received from the loan is borrowing. It becomes relevant at the sale because the payoff is larger and the check is smaller. Basis changes when you improve the property or depreciate it, not when you replace one loan with another.