Capital gains on a rental property: the bill is bigger than 15%

Ask what the tax is on selling a rental property and you'll hear "capital gains, 15%." That answer is wrong the way a weather forecast that only mentions temperature is wrong. It's one layer of four, and for most landlords it isn't even the biggest one.

If you're thinking about selling, here is the actual bill, layer by layer, with a worked example.

Layer one: capital gains

Hold a rental for more than a year and the appreciation is a long-term capital gain, taxed at 15% for most sellers and 20% above the top bracket threshold. This is the layer everyone knows. Note what it applies to, though: not your sale price minus your purchase price, but sale price minus your adjusted basis. And your basis has been shrinking the whole time you owned the property, which brings us to the layer nobody budgets for.

Layer two: depreciation recapture

Every year you operated the rental, you deducted depreciation, roughly 3.6% of the building's value annually. Those deductions lowered your taxable income, which was the point. They also lowered your basis in the property, dollar for dollar.

At sale, the IRS collects on that arrangement. The portion of your gain attributable to depreciation, what the code calls unrecaptured Section 1250 gain, is taxed at up to 25% instead of the capital gains rate. Ten years of ownership can mean $40,000 or more of accumulated depreciation, which means $10,000 of tax from this layer alone.

Two things make recapture feel unfair, and both are worth knowing in advance. It applies to depreciation you were entitled to take even if you somehow didn't take it. And no amount of living in the property later erases it.

Layers three and four: NIIT and your state

The net investment income tax adds 3.8% on investment gains for sellers with modified adjusted gross income above $200,000 single or $250,000 married filing jointly. If you're reading this, there's a decent chance that's you.

Then your state takes its share. A handful of states charge nothing. California treats the entire gain as ordinary income at rates up to 13.3%. Most states land between 4% and 6%.

A worked example

Illustrative numbers, simplified for clarity.

You bought a rental in Columbus, Georgia for $150,000 eight years ago. It sells today for $260,000. Over eight years you claimed $35,000 in depreciation. Your MAGI clears the NIIT threshold, and your state taxes gains at 5%.

• Adjusted basis: $150,000 minus $35,000, or $115,000
• Total gain: $260,000 minus $115,000, or $145,000
• Recapture: 25% of $35,000 = $8,750
• Long-term capital gains: 15% of the remaining $110,000 = $16,500
• NIIT: 3.8% of $145,000 = $5,510
• State: 5% of $145,000 = $7,250

Total: roughly $38,000, about 26% of the gain. More than two and a half times what the "15%" answer predicted. Selling costs, basis adjustments for improvements, and your specific brackets will move this number, which is what your CPA is for.

What legitimately shrinks the bill

Before the big move, the small ones. Document every capital improvement, because each dollar of improvement is a dollar of basis and a dollar less gain. Selling costs, commissions, and transfer taxes reduce the gain too. Harvested losses elsewhere in your portfolio can offset some of it. If you ever lived in the property, part of the gain may qualify for a prorated exclusion, with real limits.

Those are trims. There's exactly one tool that addresses all four layers at once.

The deferral

A 1031 exchange lets you roll the entire gain, all four layers of pending tax, into the next property. In the example above, the $38,000 that was leaving for the IRS stays invested as equity in a larger asset. Do that two or three times across a portfolio's life and the compounding difference isn't marginal, it's the whole game.

Honest framing: it's a deferral, not forgiveness. The tab follows you into each new property, and it comes due if you ever sell without exchanging. Hold until death and the stepped-up basis clears the tab entirely, which is why the investors who understand this best tend to describe their exit strategy in one word: don't.

The rules, deadlines, and failure modes of the exchange are their own subject. Start here: 1031 exchange rules for rental property. And if you're already planning a sale, the time to think about this is before you list, not after you close.

Illustrative example. Actual taxes vary based on income, state, basis, and individual circumstances. Lineage is a transaction platform, not a tax advisor. Run your numbers with a CPA before selling.