You've built equity, cultivated steady rental income, and successfully managed your asset. Now, as you plan your exit, don't let a surprise tax bill erode the profit you've worked hard to earn. Understanding the tax implications of selling your rental property is crucial for maximizing your return on investment (ROI).
This guide breaks down exactly when and how the Capital Gains Tax (CGT) is triggered on rental property sales and provides advanced, legally sound strategies for U.S. real estate investors to minimize their liability. We’ll cover the rules of applicability and the solutions for optimization in a clear, straightforward manner.
What are capital gains on a rental property?
A capital gain is the profit realized when you sell a capital asset for more than its cost. A rental property is considered a capital asset used for investment purposes.
The capital gain on a rental property is calculated by taking the net sale price and subtracting your adjusted basis (or adjusted cost). The adjusted basis is the original purchase price plus any major capital improvements, minus the total depreciation you claimed over the years. This net profit is the amount subject to the Capital Gains Tax.
What are capital gain taxes?
Capital gains taxes are the taxes levied by the government on the profits realized from the sale of capital assets, such as real estate, stocks, or bonds. You only owe this tax when the gain is realized (when you complete the sale), not while the asset is simply increasing in value (unrealized gain).
The actual tax rate you pay is determined by two primary factors:
- The holding period: How long you owned the asset.
- Your taxable income: This dictates which tax bracket your income and gains fall into.
Types of capital gain taxes
In the U.S., capital gains are divided into two main types based on the holding period, and rental properties introduce a third, special rate due to depreciation.
1. Short-term capital gains tax
Short-term capital gains are applied to the rental property when it is held for one year or less before being sold. These gains are taxed as ordinary income. This is the same rate as your wages, which can range from 10% up to 37%.
2. Long-term capital gains tax
Long-term capital gains tax are applied when you hold a rental property for more than one year before being sold. This is the most common type of capital gain tax for investors and landlords.
Long-term gains are taxed at preferential, lower rates: 0%, 15%, or 20%. Most investors aim to qualify for this because these rates are typically much lower than their ordinary income tax rate.
3. Depreciation recapture tax (special rate for rental property)
Depreciation recapture tax applies when you sell a depreciable rental property and have claimed depreciation deductions (Capital Cost Allowance) over the years.
The cumulative amount of depreciation previously claimed is "recaptured" and taxed separately at a maximum federal rate of 25%. This rate is applied before the standard long-term capital gains rate is applied to the remaining profit.
How to calculate tax on capital gain?
Calculating capital gain taxes involves knowing your capital gains and determining the tax liability on them.
But, before we do that, there are a few key variables you should know about:
- Proceeds of Disposition: This is the total selling price of your property minus the costs directly related to the sale itself, such as real estate agent commissions, legal fees, and title insurance.
- Adjusted Cost Base (ACB): This is your original investment in the property. It includes the purchase price, specific land transfer taxes, and the total cost of all capital expenditures (major improvements like a new roof, HVAC system, or addition) made over the years.
- Selling Expenses: These are the costs incurred to execute the sale, deducted from the gross sale price to arrive at your net proceeds
The basic formula is: Proceeds of Disposition − (Adjusted Cost Base + Selling Expenses) = Capital Gain
The capital gain is then used to determine your final tax liability.
In the U.S., a significant break exists: only a portion of the long-term capital gain (for assets held more than one year) is typically added to your taxable income. This is often referred to as an inclusion rate, and the maximum long-term capital gains tax rates are generally much lower than ordinary income tax rates.
Tricky triggers: changes in use and recapture
As a landlord, you need to be aware of two "tricky triggers" that can create a tax event without a traditional sale.
- Principle Residence Conversion (Deemed Disposition): If you move from a rental property into a personal home, or vice-versa, the IRS considers this a "change in use," which can be treated as a deemed disposition. This means the government acts as if you sold the property to yourself at its fair market value, potentially triggering a capital gain (or loss) event at that moment, even though no money changed hands.
- Recapture of Depreciation (Capital Cost Allowance): This is a crucial point for experienced investors. The Capital Cost Allowance (CCA), or depreciation, is a deduction you claim each year on your rental income (reported on Schedule E of your tax return). Upon sale, the total amount of depreciation previously claimed must be "recaptured" and added back to your taxable income. This recaptured amount is taxed as ordinary income, not at the lower capital gains rate
Federal capital gains tax rates for rental property 2025
After accounting for depreciation recapture, the remaining gain on your rental property sale is subject to federal capital gains tax rates. These rates depend on your total taxable income and filing status. The rates differ for short-term and long-term gains.
Below are the rates for long-term capital gains.
- Short-term capital gains are taxed as ordinary income according to federal income tax brackets.
- Any portion of the gain that is attributable to depreciation you previously claimed on the rental property (unrecaptured Section 1250 gain) is taxed at a maximum federal rate of 25%.
Note on Additional Tax: High-income taxpayers may also be subject to an additional 3.8% Net Investment Income Tax (NIIT) on their investment income, including capital gains.
Strategies to minimize your tax liability
While capital gains are a natural result of a profitable investment, you can use several proven, legal strategies to reduce your final tax bill.
Take advantage of tax-loss harvesting
Tax-loss harvesting is a strategy where, if you have other investments—like stocks or a different rental property—that you sold at a loss in the same year, you can use these capital losses to offset the gain from your profitable rental sale. This strategy effectively lowers your net capital gain.
If your capital losses exceed your capital gains, you can use up to $3,000 of the remaining loss to offset ordinary income per year. Any remaining loss can be carried forward to offset future gains. This strategy requires owning other assets in a taxable account that have declined in value.
This can be a useful tool to reduce your overall tax liability in the year you sell a rental property with a significant gain. It requires coordinating the sale of your rental property with the sale of other assets.
Sell in a low-income year
Capital gains tax is calculated based on your overall marginal tax rate in the year of the sale. If you anticipate a year where your regular employment or business income will be lower (e.g., retirement, sabbatical), selling your property in that year may allow your capital gain to fall into a lower tax bracket, resulting in significant savings.
This planning should be done in consultation with a tax professional to analyze the potential impact on your overall tax situation.
Use a capital gains reserve
If you are the seller and arrange to receive the proceeds of the sale over a period of several years (not all in the year of sale), you can use a Capital Gains Reserve. This allows you to report and pay the tax on the gain only as you receive the money, spreading the tax burden over multiple tax years.
Apply the principal residence exemption (pre) strategy
If you lived in your rental property at one point, you may be able to apply the PRE for the years it qualified as your principal residence. While complex, this exemption shields a portion of the overall gain from tax. You must file an election with the IRS to avoid the "deemed disposition" rule when the property's use changes.
Incorporate the rental business
Operating your rental business under a Limited Liability Company (LLC) or corporation can change how your investment is taxed. While corporate taxation is more complex, it can provide tax benefits for reinvesting profits back into the business, asset protection, and legal separation of your finances. [Internal Link: Relevant Baselane Feature or Blog Post on LLCs and Business Banking]. We recommend you use a platform that supports separate banking accounts for multiple entities to keep your finances organized and compliant.
Transfer ownership to a spouse/partner
In certain cases, selling a portion of the property to your spouse or partner who has a lower marginal tax rate can legally allow the future gain to be taxed at their lower rate—a concept known as income splitting. This must be done carefully to comply with attribution rules.
Increase ACB through capital improvements
As mentioned earlier, the cost of capital improvements increases your property's adjusted cost basis. A higher ACB results in a lower taxable capital gain. Therefore, to reduce your tax liability, make smart capital improvements.
Examples of capital improvements include adding a deck, replacing the HVAC system, or remodeling a kitchen or bathroom. Keep meticulous records and receipts for all capital improvements to calculate your adjusted basis upon sale accurately.
Note: Capital improvement differs from routine repairs. Repairs maintain the property's current condition and are typically deductible as expenses in the year incurred. Capital improvements, however, add value, prolong life, or adapt the property for new uses and are added to the basis.
Claim all selling costs
Account for all the legitimate selling expenses such as real estate agent commissions, escrow fees, title insurance costs, real estate photography, legal fees, and transfer taxes. Deduct these expenses from the sales proceeds to reduce your Proceeds of Disposition.
To benefit from this strategy, you must maintain a clear record of all the expenses incurred over a year. With Baselane’s auto-categorization feature, you can tag each transaction to a specific property and Schedule E category. This helps you get a customized report and helps you filter the selling expenses you need to show in your legal documents.
Manage your capital gain taxes with Baselane
Capital gains are unavoidable on a profitable rental sale, but they are not an immutable tax figure. The key to successful, tax-optimized investing is not just making a profit, but ensuring you keep the largest share of it.
Meticulous record-keeping and strategic planning long before the sale are the keys to optimization. Knowing your ACB, carefully tracking capital improvements, and planning the timing of your sale are all non-negotiable steps.
The complexity of these rules—especially regarding depreciation recapture and calculating the ACB—necessitates professional software tools or a qualified tax professional to ensure maximum savings and compliance.
The best return on investment includes the most efficient tax outcome. Open a free Baselane account today to start automatically tracking all your income and capital expenditures, making tax time effortless.
FAQs
What is a capital gain on rental property?
A capital gain on rental property is the profit you make when you sell it for more than your adjusted basis. This gain is typically subject to capital gains tax. The adjusted basis includes your purchase price, capital improvements, minus depreciation claimed.
How is capital gains tax calculated for rental property?
Capital gains tax is calculated on the difference between the sale price (minus selling expenses) and your adjusted basis. This total gain is then separated into depreciation recapture (taxed up to 25%) and the remaining gain (taxed at 0%, 15%, or 20% depending on income and holding period).
Is depreciation recapture taxed differently from capital gains?
Yes, depreciation recapture is taxed separately from the standard capital gain. The portion of your gain equivalent to the depreciation you claimed is taxed at a maximum rate of 25%, regardless of your income tax bracket or the long-term capital gains rates.
How can I avoid capital gains tax on rental property?
You cannot entirely avoid capital gains tax in a taxable sale if you realize a gain. However, you can defer it using strategies like a 1031 exchange, or exclude a portion of it by converting the property to your primary residence under Section 121 rules, if you qualify. Reducing the taxable gain through increased basis from capital improvements or deducting selling expenses also lowers the tax owed.
What is the 1031 exchange rule for rental property?
The 1031 exchange rule allows you to defer capital gains tax by reinvesting sale proceeds from one investment property into a "like-kind" replacement property. You must identify the new property within 45 days of the sale and complete the exchange within 180 days. The properties must be used for investment or business purposes.
