Selling Rental Property: Depreciation Recapture, Capital Gains, and 1031 Exchange Options

By Yarik Yarosh, CPA ·September 5, 2026 ·Updated September 23, 2026 ·9 min read

Written by Yarik Yarosh, CPA (US & Canada) September 5, 2026 · FL CPA license AC61704 · CPA Ontario

The tax bill on selling a rental property catches many investors off guard. During ownership, depreciation deductions reduce taxable income and feel like free tax savings. But the IRS treats those deductions as borrowed, not given, and collects them back at sale through depreciation recapture under IRC 1250. Every dollar of straight-line depreciation deducted (or that should have been deducted, even if the investor failed to claim it) becomes unrecaptured section 1250 gain, taxed at a maximum 25% rate. On top of that, any appreciation above the original purchase price is taxed as long-term capital gains (0%, 15%, or 20% depending on income), and the 3.8% net investment income tax under IRC 1411 applies to both components for higher-income taxpayers. The combined effective rate on a profitable rental property sale can exceed 30%. The primary tool for avoiding this tax is the IRC 1031 like-kind exchange, which defers all gain (both depreciation recapture and capital gain) when the proceeds are reinvested in another investment property.

✓Key takeaway

Tax components when selling a rental property:

Component	Tax Rate	Applies To
Unrecaptured section 1250 gain	25% (maximum)	Straight-line depreciation taken or allowed during the holding period
Long-term capital gains	0%, 15%, or 20% (depending on income)	Appreciation above original cost basis
Net investment income tax (IRC 1411)	3.8%	Both components, if MAGI exceeds $200,000 single / $250,000 MFJ
State income tax	Varies by state	Depends on the state’s rules for capital gains

Key definitions:

Term	Calculation
Original basis	Purchase price + closing costs + improvements
Adjusted basis	Original basis minus accumulated depreciation
Amount realized	Sale price minus selling costs (commissions, closing costs)
Total gain	Amount realized minus adjusted basis
Unrecaptured section 1250 gain	Total straight-line depreciation taken or allowed (capped at total gain)
Capital gain	Total gain minus unrecaptured section 1250 gain

How much tax will you owe when you sell a rental property?

Hypothetical example

Round numbers. An investor sells a residential rental property.

Property history:

Item	Amount
Original purchase price (2015)	$500,000
Closing costs (capitalized)	$15,000
Capital improvements (new roof, HVAC, kitchen)	$85,000
Original cost basis	$600,000
Land value (not depreciable)	$100,000
Depreciable basis	$500,000
Annual depreciation ($500,000 / 27.5 years)	$18,182/year
Years held (2015-2025)	10 years
Total depreciation taken	$181,820
Adjusted basis	$418,180 ($600,000 - $181,820)

Sale details:

Item	Amount
Sale price	$850,000
Selling costs (agent commissions, closing)	$50,000
Amount realized	$800,000

Gain calculation:

Component	Amount
Amount realized	$800,000
Adjusted basis	($418,180)
Total gain	$381,820
Unrecaptured section 1250 gain (lesser of total depreciation or total gain)	$181,820
Capital gain (total gain minus unrecaptured 1250 gain)	$200,000

Tax calculation (assume MFJ, $300,000 other income, top brackets):

Tax Component	Amount	Rate	Tax
Unrecaptured section 1250 gain	$181,820	25% (max)	$45,455
Long-term capital gain	$200,000	20%	$40,000
Net investment income tax (NIIT)	$381,820	3.8%	$14,509
State tax (assume 5%)	$381,820	5%	$19,091
Total tax on sale			$119,055
Effective rate on $381,820 gain			31.2%

On an $850,000 sale, the investor keeps $800,000 (after selling costs) minus $119,055 in taxes = $680,945 in after-tax proceeds.

What if the investor never claimed depreciation?

Rule	Details
”Allowed or allowable”	The IRS recaptures depreciation that was ALLOWED (taken) or ALLOWABLE (should have been taken), whichever is greater
Result	Even if the investor forgot to deduct depreciation for all 10 years, the IRS still taxes $181,820 as unrecaptured 1250 gain at up to 25%
Remedy	File Form 3115 (Change of Accounting Method) to claim the missed depreciation as a one-time catch-up deduction

1031 Exchange (tax deferral):

Requirement	Details
Like-kind property	Any real property held for investment or business (residential to commercial is fine)
Equal or greater value	Replacement property must be equal or greater in value; any cash received is taxable “boot”
Equal or greater debt	Must take on equal or greater mortgage to avoid boot
45-day identification	Must identify up to 3 replacement properties (or more under the 200% or 95% rules) within 45 calendar days
180-day closing	Must close on the replacement property within 180 calendar days
Qualified intermediary	Must use a QI; can’t touch the proceeds
Same taxpayer	Same taxpayer on both deeds (can use a single-member LLC as a disregarded entity)

1031 exchange on the above property	Amount
Sale price	$850,000
Tax deferred	$119,055
Replacement property purchased	$850,000+ (apartment building)
New adjusted basis	$418,180 (carryover)
New annual depreciation	Based on the new property’s cost segregation

Boot (taxable portion of a 1031 exchange):

Type of Boot	Example	Tax
Cash boot	Receive $50,000 cash from the exchange	$50,000 taxable (gains recognized up to boot amount)
Mortgage boot	Old mortgage: $300,000; new mortgage: $250,000	$50,000 mortgage boot (taxable)
Unlike property	Receive personal property (e.g., furniture) in the exchange	FMV of unlike property is taxable

Installment sale (IRC 453): If the buyer pays over time, the gain is spread over the payment period:

Terms	Details
Sale price	$850,000
Down payment (20%)	$170,000
Installment note	$680,000 over 10 years at 7% interest
Gross profit percentage	$381,820 / $850,000 = 44.92% (selling costs are added to basis, not subtracted from the contract price)
Gain recognized on down payment	$170,000 x 44.92% = $76,364
Gain recognized on each annual payment	$68,000 x 44.92% = $30,546
Interest income on note	Taxable as ordinary income

Note: Only depreciation recapture income (for a building, depreciation beyond straight-line) must be reported in the year of sale. A residential rental depreciated straight-line has none, so the $181,820 of unrecaptured 1250 gain is reported under the installment method as payments come in, ahead of the rest of the gain, taxed at up to 25%.

Year of sale tax (installment sale)	Amount
Recapture income required in Year 1 (straight-line rental)	$0
Tax on gain from the down payment ($76,364, all unrecaptured 1250 gain, which is taken into account before the rest of the gain)	$76,364 x 25% = ~$19,090
NIIT on Year 1 gain	~$2,900
Year 1 tax	~$21,990
Later years’ tax (unrecaptured 1250 gain first at 25%, then 20%, plus 3.8% NIIT)	~$8,800/year on the next three payments, ~$7,960 on the fourth, then ~$7,270/year

Comparison of exit strategies:

Strategy	Year 1 Tax	Total Tax Over Time	Pros	Cons
Outright sale	$119,055	$119,055	Simple; cash immediately	Full tax hit
1031 exchange	$0	$0 (deferred)	No current tax; larger reinvestment base	Must buy replacement property; strict deadlines
Installment sale	~$21,990	~$119,055 (spread over 10 years)	Spreads tax; interest income	Recapture income (if any) not deferrable; credit risk on buyer
Hold until death	$0 (during lifetime)	$0 (stepped-up basis eliminates gain)	No tax ever	Must hold until death; illiquid
Charitable remainder trust	Varies	Reduced (income stream to donor)	Tax deduction; income stream; avoids capital gains	Complex; irrevocable; remainder goes to charity
Delaware Statutory Trust (DST)	$0 (via 1031)	Deferred	Passive management; qualifies as 1031 replacement	Lower returns; fees; less control

Illustrative numbers only, not a real client and not advice for your facts.

What is the difference between short-term and long-term capital gains rates?

Assets held for one year or less generate short-term capital gains, taxed at your ordinary income tax rate (up to 37% federal). Assets held for more than one year qualify for long-term capital gains rates of 0%, 15%, or 20%, depending on your taxable income. High-income taxpayers may also owe the 3.8% net investment income tax (NIIT) under IRC 1411 on top of the capital gains rate. The holding period starts the day after you acquire the asset and includes the day you sell it. For business owners planning a sale, timing the disposition to cross the one-year threshold can save 15-20 percentage points in federal tax on the gain.

Can I offset capital gains with capital losses from other investments?

Yes. Capital losses first offset capital gains of the same type (short-term losses against short-term gains, long-term against long-term), then any remaining net loss offsets gains of the other type. If net capital losses exceed capital gains, you can deduct up to $3,000 of the excess against ordinary income ($1,500 if married filing separately). Unused losses carry forward indefinitely to future tax years, maintaining their character (short-term or long-term). The wash sale rule (IRC 1091) prevents you from claiming a loss if you repurchase substantially identical securities within 30 days before or after the sale. Tax-loss harvesting before year-end is a common strategy to realize losses that offset gains elsewhere in the portfolio.

Related guides:

Is rental depreciation taxed at a flat 25% when you sell?

No, 25% is a ceiling. The straight-line depreciation on a rental building becomes unrecaptured section 1250 gain, taxed at a maximum 25%, so the rate on that slice can be lower depending on your bracket. Section 1250 only treats depreciation beyond straight-line as ordinary income, and a rental depreciated on the normal straight-line schedule generally has none of that.

Appreciation above your original cost gets long-term rates if you held the property more than one year. For 2025 that’s 0% up to $96,700 of taxable income for joint filers, 15% up to $600,050 and 20% above; for 2026 the ceilings are $98,900 and $613,700. The 3.8% net investment income tax can apply on top once modified AGI passes $250,000 joint or $200,000 single, and those thresholds aren’t indexed.

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Cite this page

Yarik Yarosh, CPA. "Selling Rental Property: Depreciation Recapture, Capital Gains, and 1031 Exchange Options." Blue Cloud CPA, September 5, 2026, updated September 23, 2026. https://bluecloudcpa.com/guides/small-business-selling-rental-property-depreciation-recapture-1031

This guide is general information, not tax advice for your specific situation. Which points apply, and how, depends on your facts.