Real estate & rental
Selling a Rental Property: The Full Tax Bill, Line by Line
The tax on selling a rental isn't one number — it's a stack: depreciation recapture at up to 25%, capital gain on the rest, the 3.8% NIIT on top, and California taxing all of it as ordinary income. Here's the whole stack computed on one sale, and the two exits that defer or erase it.
8 min read · Published September 2026
Key Takeaways
- The gain on a rental sale is amount realized minus adjusted basis, and depreciation reduces that basis whether or not you actually claimed it — the IRS uses 'allowed or allowable,' so skipping the deduction is pure loss.
- The tax isn't one rate. Straight-line depreciation comes back first as unrecaptured §1250 gain (up to 25%), the rest is a regular long-term capital gain (0/15/20%), the 3.8% NIIT layers on top, and California taxes the whole thing again as ordinary income up to 13.3%.
- On the worked example below — a $367,000 gain — those four layers add up to roughly $128,700 in combined tax, about 35% of the gain, before any cost segregation recapture.
- A complete taxable disposition releases every suspended passive loss from that property in full the same year, under IRC §469(g) — years of trapped paper losses finally offset the gain.
- Two exits make this bill optional: a 1031 exchange defers the entire stack, and holding the property until death erases it — heirs take a stepped-up basis and the depreciation never comes back.
The numbers below are illustrative, not a real client’s — this site isn’t attached to a firm, so there isn’t one.
Start with the gain, not the tax
Every layer below is computed off one number: the gain — amount realized (sale price minus selling costs) minus adjusted basis (purchase price plus capital improvements minus accumulated depreciation). That last piece is where owners get surprised: it applies whether or not the depreciation was actually claimed.
This $367,000 carries through every layer below. It's the number the IRS, the NIIT, and California all start from — they just tax different slices of it, at different rates, on different forms.
'Allowed or allowable' means depreciation isn't optional at sale
Layer one: unrecaptured §1250 gain, up to 25%
The straight-line depreciation taken on the building comes back first. This slice — unrecaptured §1250 gain — is taxed at ordinary rates but capped at a maximum federal rate of 25%, regardless of the seller’s bracket. Here, that’s the entire $109,000 of accumulated depreciation: 25% × $109,000 = $27,250.
Layer two: the remaining gain, at capital gains rates
Whatever’s left of the $367,000 gain after the recapture slice is a regular long-term capital gain, taxed at the ordinary 0/15/20% federal brackets. That’s $367,000 − $109,000 = $258,000. For a seller already in the top capital gains bracket, 20% × $258,000 would apply — but assume this couple lands in the 15% bracket instead: 15% × $258,000 = $38,700.
The 25% recapture rate isn’t a penalty. It’s the bill for deductions you already cashed, years ago, one tax return at a time.
Layer three: the 3.8% NIIT
Gain on a rental sale is investment income, and the 3.8% Net Investment Income Tax applies on top of whatever federal rate the gain already faces, once modified AGI exceeds $200,000 single or $250,000 married filing jointly. Assume this couple’s other income already sits above the $250,000 MFJ threshold before the sale, so the entire $367,000 gain counts as net investment income: 3.8% × $367,000 = $13,946.
Layer four: California taxes all of it as ordinary income
California has no preferential capital gains rate — none of the federal 0/15/20% treatment, and no 25% cap on the recapture slice either. The state taxes the entire $367,000 gain as ordinary income, at California’s regular rates up to 13.3%. Assuming this sale lands the couple in the top bracket: 13.3% × $367,000 = $48,811 — the single largest layer in the whole stack.
About 35% of the gain, before any cost segregation recapture and before crediting suspended passive losses — both covered below, and both able to move this number in either direction.
If a cost segregation study was done
Any part of the purchase reclassified into 5, 7, or 15-year property under a cost segregation study skips the 25% cap at sale. Depreciation on that reclassified §1245 property recaptures at full ordinary rates — up to 37% federal, plus NIIT and California on top — which can push that slice above what the unrecaptured §1250 gain pays. Not a reason to skip the study; a reason to weigh the acceleration against the eventual recapture rate together.
The good news: suspended passive losses release in full
The example above assumed no prior suspended losses. Many long-held rentals carry years of passive losses with no passive income to absorb them — trapped in carryforward under the passive activity loss rules. A complete taxable disposition changes that: under IRC §469(g), every suspended loss tied to the property releases in full the year of the sale, no income limits attached. A decade of paper losses that helped no prior return can offset a meaningful slice of this same gain.
Two exits that make the whole stack optional
A 1031 exchange defers every layer — recapture, capital gain, NIIT, California — by rolling the basis into a replacement property instead of recognizing the gain. The deadlines don’t bend: 45 days to identify a replacement, 180 to close, both from the original closing. Holding the property until death is the other exit, and it’s permanent, not deferred — heirs take a fair-market-value basis at death, and the depreciation never comes back.
A related but narrower option: if the property was once your primary home, the §121 exclusion can shelter part of the gain — but only the qualified-use portion, and never the recapture. The nonqualified-use math is detailed enough that it’s a separate analysis, not something to assume covers a sale on its own.
| Sell outright | 1031 exchange | Hold until death | |
|---|---|---|---|
| Tax due now | The full stack — here, $128,707 | $0 (deferred) | $0 (never, for this owner) |
| Basis afterward | N/A — property is sold | Carries over, reduced, into the replacement property | Heirs get a fair-market-value step-up |
| When the tax comes due | Now | When a future sale isn't also exchanged | Never — recapture and gain both disappear |
Installment sales: spreads the gain, not the recapture
An installment sale lets a seller collect payments — and recognize the capital gain portion — across several tax years instead of all at once, which can matter for staying under NIIT or California’s top bracket in any single year. Recapture doesn’t get that flexibility: the full recaptured amount is recognized as income in the year of sale regardless of when the cash actually arrives.
See what a 1031 exchange would defer on your sale
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Frequently asked
Questions owners actually ask
- Is this a real client situation?
- No — the numbers below are illustrative. There's no firm behind this site and no client relationship being described.
- I never claimed depreciation on this property — do I still get recaptured?
- Yes. The IRS calculates recapture on depreciation 'allowed or allowable' — the amount you were entitled to deduct, whether or not you actually claimed it. Skipping the deduction doesn't reduce the recapture bill; it just means you paid for it without getting the benefit. A Form 3115 accounting method change can catch up the missed depreciation as a single deduction before you sell, which is worth doing well ahead of a listing, not after an offer is signed.
- Can I just move into it for two years and exclude the gain under Section 121?
- Partially, and it's easy to overestimate how much it helps. The §121 exclusion ($250,000 single / $500,000 married filing jointly) only applies to the portion of ownership counted as qualified use as a primary residence — years the property was rented count as nonqualified use and stay taxable on a pro-rata basis. Depreciation recapture is carved out entirely; it's taxed regardless of how much of the gain the exclusion otherwise covers. The nonqualified-use math gets detailed fast and is beyond what this article covers — treat it as a partial offset to plan around, not a way to erase the sale.
- Does an installment sale avoid depreciation recapture?
- No. An installment sale lets you spread the capital gain portion across the years you actually collect payments, which can be a real benefit for staying under NIIT or California bracket thresholds. But depreciation recapture doesn't get that treatment — the full recaptured amount is recognized as income in the year of sale no matter how the payments are scheduled.
- What if I sell the rental at a loss instead of a gain?
- Different rules entirely — there's no recapture to worry about because recapture only applies against a gain. Rental property is generally §1231 property, so a loss on sale is an ordinary loss, fully deductible against any income in the year of sale rather than capped at the $3,000 annual limit that applies to capital losses. It's one of the few places the tax code treats a real estate loss more generously than a capital loss.
- Does a 1031 exchange defer the NIIT and California tax too, or just the federal capital gain?
- All of it. A valid 1031 exchange defers recognition of the entire gain — recapture, capital gain, NIIT, and California all compute off the same recognized-gain number, so deferring the gain defers every layer built on top of it. Nothing is recognized until (and unless) you eventually sell without exchanging again.
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Educational content only. This article is for informational purposes and does not constitute tax, legal, or financial advice. Every situation is different — consult a qualified professional before acting on anything here.