When you sell a rental property, the tax bill often surprises people. Most investors expect to pay capital gains rates on the profit, but there are actually three separate tax layers, each taxed at a different rate. Understanding them before you sell gives you time to plan.
What Is Your Adjusted Basis When You Sell?
Your taxable gain is the sale price minus your adjusted basis. Adjusted basis starts with what you paid, adds capital improvements, and subtracts all depreciation you claimed (or were required to claim) over the years.
Depreciation reduces your basis even if you forgot to take the deduction. The IRS reduces your basis by the full amount you were allowed to deduct. This reduction applies whether you claimed the deduction or missed it. If you have unclaimed depreciation, a tax professional can catch up those deductions before the sale.
For a residential rental, the building depreciates over 27.5 years using straight-line depreciation. Land is never depreciated. If you purchased a property for $350,000 and allocated $300,000 to the building, your annual depreciation is $10,909. After 8 years, you would have claimed $87,272 and your adjusted basis would be $262,728, plus capital improvements.
How the Three Tax Layers Work
Assume you sell the property above for $450,000 net of selling costs. Your realized gain is $450,000 minus $262,728, or $187,272. That gain breaks into three pieces:
Layer 1: Unrecaptured Section 1250 gain. This equals your total straight-line depreciation on the real property (building), capped at the total gain. Here, $87,272 is taxed at a maximum 25% rate. Your actual rate depends on your other income but cannot exceed 25%.
Layer 2: Section 1245 ordinary recapture. This layer applies only if you performed a cost segregation study or took accelerated depreciation on personal property components within the rental (appliances, flooring, cabinets, land improvements). All depreciation on those components is recaptured at ordinary income rates, up to 37% in 2026. For a standard residential rental with only straight-line depreciation on the building, this layer is zero.
Layer 3: Section 1231 gain. Any remaining gain above the recaptured depreciation is a Section 1231 gain. If you held the property more than one year, this flows to Schedule D and is taxed at 0%, 15%, or 20% long-term capital gain rates based on your total taxable income. Here, $187,272 minus $87,272 leaves $100,000 of Section 1231 gain.
Does the 3.8% Net Investment Income Tax Apply?
If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), all three gain layers are subject to the 3.8% Net Investment Income Tax under IRC Section 1411. This is in addition to the rates above. On $187,272 of total gain with full NIIT exposure, that adds another $7,116.
You can reduce your MAGI before the sale to minimize or eliminate NIIT exposure. Strategies include accelerating deductible expenses, maximizing retirement plan contributions, and timing the closing near year-end to spread income.
How to Report the Sale on Form 4797
The sale is reported on Form 4797, Sale of Business Property. For a residential rental held more than one year:
- Unrecaptured Section 1250 gain flows through Part III and then Part I (the 25% layer is captured on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions)
- The Section 1231 gain from Part I carries to Schedule D, Line 11
- Any Section 1245 ordinary recapture appears in Part III as ordinary income
Accurate reporting requires the original purchase price and land-to-building allocation, a record of all capital improvements, total depreciation claimed on Form 4562 each year, and the final sale price net of commissions and closing costs.
Can You Defer the Tax on a Rental Property Sale?
1031 exchange. A like-kind exchange under IRC Section 1031 defers all three tax layers. You must identify a replacement property within 45 days of closing and complete the purchase within 180 days. The deferred gain carries into the replacement property's basis, reducing future depreciation, and remains deferred until you sell without exchanging.
Installment sale. Under IRC Section 453, you can spread the Section 1231 capital gain portion across multiple years by receiving payments over time. Section 1245 ordinary recapture, however, is recognized in full in the year of sale regardless of when you actually receive the cash.
Holding until death. Heirs receive a stepped-up basis to fair market value at death under IRC Section 1014. This eliminates all embedded gain, including every dollar of accumulated depreciation. For older or terminally ill property owners, holding can be more valuable than any deferral strategy.
Planning a rental property sale and want to understand your full tax exposure before you close? Contact TS CPA for a free consultation. We respond within the same day.