Capital gain on a rental property is not simply the sale price minus what you paid. The gain is measured against your adjusted basis, which is what you paid, plus improvements, minus every year of depreciation you were entitled to take. Then the gain splits in two and each part is taxed at a different rate. Owners who use the simple subtraction come out low, and usually by more than expected.

Most owners already have a number in their head. I bought it for this, I can sell it for that, the difference is my gain.

That approach is almost always wrong. For a rental you have owned for several years, that number is usually too low.

The arithmetic is not the problem. The problem is that two things happened while you owned the property, and the simple subtraction does not account for either one. You took depreciation every year, which lowered your basis. And selling costs real money, which lowers what you actually walk away with. Both change the result, and one of them changes it more than you would expect.

Your basis is not what you paid

Your basis starts at the purchase price, including some of the closing costs from when you bought. After that it moves in two directions.

It goes up when you make a capital improvement, like a new roof, a new furnace, an addition, or a full kitchen. Something that adds value or extends the life of the property, rather than just keeping it running.

It goes down while the property is in service, by the depreciation you were allowed to take.

That second one is where the money often hides. Residential rental property is depreciated over 27.5 years, and only on the building, because land does not wear out. On a property where the building is worth $150,000, that is about $5,455 a year coming off your basis, every year, whether or not you ever thought about it. Ten years of that is roughly $54,500. Twenty years is roughly $109,100. IRS Publication 527 covers depreciation on residential rental property.

There is a rule attached to this that catches people, and it is worth knowing before you sell. Your basis drops by the depreciation you were allowed to take, whether or not you took it. Skipping the deduction does not protect your basis. You gave up the deduction but your basis dropped nonetheless. This comes up most with owners who turned a former home into a rental and never set up a schedule, and what it costs is covered in depreciation recapture.

All of this depends on records rather than memory. What you paid, what you spent on improvements and when, and what depreciation was actually claimed. If you cannot find the depreciation schedule from prior returns, that is the first thing to look for, because everything downstream is dependent upon it.

Selling costs come off the other side

The second adjustment is easier. What you compare against basis is not the sale price. It is what you actually realize, which is the sale price minus what it cost to sell.

Commission, title and closing costs, transfer taxes, and anything you credit the buyer all come out of what you get at closing. On a typical sale that runs somewhere in the 6 to 9 percent range, and it happens before the gain can be figured.

That one works in your favor. It is also the piece many owners leave out or underestimate. Leaving it out partly cancels the depreciation surprise you may not have planned for. It is why some people end up close to the right answer by accident.

The gain splits in two

This is the part that has no real equivalent when you sell something like a publicly traded stock, and it can move the number more than almost anything else.

Once you have the total gain, part of it gets separated out. The part that traces back to the depreciation you took is called unrecaptured Section 1250 gain, and it is taxed at a maximum of 25 percent rather than at the capital gains rate. It cannot be larger than the gain itself, and the exact amount comes off a worksheet your preparer runs. Maximum matters here. The actual rate can be lower than 25 percent depending on your taxable income. If yours is lower, you pay the lower one. Whatever is left over is long term capital gain, taxed at the capital gains rate. IRS Publication 544 covers sales of business property and the Section 1250 rules.

So the depreciation you claimed every year did not go away. It lowered your taxable income while you owned the property, at your ordinary rate, and a matching amount of gain comes back at up to 25 percent when you sell. Whether that helped depends on your tax rate when you took the deduction and your rate when you sell.

How long you owned it decides which rate applies

If you owned the property more than a year before selling, the gain gets long term treatment. A year or less and it is short term, taxed at your ordinary rate, which for most owners is worse than the capital gains rate.

For a rental this is rarely the real question, because most owners are years past that line before they start thinking about selling. It most often matters on a flip, though, and on a purchase that turned into a mistake.

Long term capital gains are taxed at 0, 15 or 20 percent depending on your taxable income. The rate structure is set by Congress. The income levels that decide which of the three applies to you are adjusted every year for inflation, so look up the current figures rather than working from a number you remember. IRS Topic No. 409 has them.

The key point is this. The same house sold by the same person in two different years can be taxed differently, and a large gain can push part of itself up into a higher band. Why the year matters is a subject of its own.

Running the numbers on one house

These numbers are here to show how the math works. They are not a forecast and yours will be different.

Say you bought a rental twelve years ago for $187,500, and it rents for $1,800 a month. Land was 20 percent of the price, so the building was $150,000 and depreciation ran about $5,455 a year. Eight years in you replaced the roof for $12,000.

Twelve years of depreciation comes to $65,455. Add the roof to the purchase price and take the depreciation off, and your adjusted basis is $134,045.

Now sell it for $300,000. Selling costs at 8 percent are $24,000, so you realize $276,000. Subtract the basis and the gain is $141,955.

Then you need to split it:

  • The part tied to depreciation, which here is $65,455, taxed at up to 25 percent, so about $16,364
  • What is left, being $76,500, at 15 percent, so about $11,475
  • Federal total: about $27,839

To keep the example above simple, it ignores the fact that the roof has its own depreciation schedule and the first year of ownership is a partial year. Both would move the figure a little.

What the simple version said

The number in the owner's head was $300,000 minus $187,500, a gain of $112,500, and at 15 percent a bill of about $16,875.

Under the rates used in this example, the federal estimate is about $27,839. That is roughly $11,000 more taxes owed than expected, even though nothing unusual happened on that sale.

The selling costs helped. The depreciation more than wiped that out, and the 25 percent band did the rest.

The 3.8 percent that can land on top

There is another tax that shows up for higher earners, and it surprises people because it is usually not part of the capital gains conversation at all.

There is a net investment income tax that adds 3.8 percent. It applies to the lesser of your investment income for the year or the amount your modified adjusted gross income goes over the threshold. The thresholds are $200,000 filing single and $250,000 filing jointly, and unlike the capital gains bands they are fixed in law rather than adjusted for inflation, so unfortunately, more people cross them every year.

That second part is important for how much you would actually owe. If your income clears the line by $40,000, the 3.8 percent applies to just that $40,000, not to the whole gain. If you are well over the line, the whole gain could be exposed. On the sale example above, the most it could add is about $5,394, which would take the total to roughly $33,233.

State income tax is also something that needs to be factored in. Some states tax the gain as ordinary income, a few do not tax it at all, and a property in one state owned by a resident of another has its own rules.

Old losses can work in your favor

One item can help you though, and owners rarely count it because they forgot about it.

If you were not able to deduct rental losses in past years because of the passive activity loss rules, those losses were carried forward rather than lost. When you sell your entire interest in a fully taxable sale to an unrelated buyer, losses suspended on that activity generally become available. For somebody who has accumulated several years of them, that can be a real offset against the gain in the year you sell.

How much you have and whether it applies depends on your own history and how the property is held, so it is worth asking your preparer rather than assuming it would be available as an offset.

What the number is actually for

None of this tells you whether to sell.

It is written to help you consider the factors that belong in the comparison. On the example above, after paying off a loan balance of about $112,000, you walk out of closing with roughly $164,000 and then owe somewhere between $27,000 and $33,000 of it. What is left, about $130,000 to $136,000, is what you have to buy the next property, pay down another loan, or put in an account. That is what you compare against holding. It is not the sales price or the equity on your loan statement.

It is also the number a 1031 exchange gets measured against. An exchange defers the gain and the recapture rather than eliminating them, so the comparison is the deferred version against the taxable version against simply keeping the property and not selling at all. The important consideration here is that the deferral is worth real money to you. It is also the reason people accept replacement properties they would have walked past in a different situation. Deferring the tax is a strategy to keep more of the sale proceeds, but if it means buying a property you would not have otherwise considered, it may not be the better decision long term.

And this is for just one property. Selling changes the income, the leverage, and the concentration across everything you own, and whether that is progress depends on what the portfolio is supposed to do. A sale that produces a clean number and sets the plan back two years is still a bad sale. The full version of that comparison is whether to sell the property or keep it.

Your own number depends on your records, your improvement history, your depreciation history, your income in the year of sale, your state, how the property is held, and whether you have suspended losses. Most of those need documents and not your best recollection. You will need to work the figures with a CPA before you commit to a price or a closing date, because by the time you are under contract most of it is already decided.

Novarif is being built to show what a sale actually leaves you with after tax, and what that does to income, coverage, equity, and the goal across the whole portfolio. Join early access to see the number before you list.