Capital Gains Tax On A Rental Property Sale

The starting point is adjusted basis: the original purchase price, plus capital improvements such as a new roof or an addition, minus total depreciation claimed over the holding period, including depreciation the owner was entitled to take even in years it was not actually deducted. That adjusted basis is subtracted from the net sale price, after commissions and closing costs, to produce the total gain. From there, the gain splits into a depreciation-recapture portion, taxed under Section 1250 at a rate capped at 25 percent, and a remaining appreciation portion, taxed at the applicable long-term capital gains rate if the property was held over a year.

A Bellingham fourplex bought for 500,000 dollars, with 120,000 dollars of depreciation claimed and 30,000 dollars in documented improvements, sells for 900,000 dollars net of costs. Adjusted basis is 410,000 dollars, producing a total gain of 490,000 dollars. Of that, 120,000 dollars is taxed as depreciation recapture, and the remaining 370,000 dollars is taxed at ordinary long-term capital gains rates. The combined federal liability on a sale like this commonly runs into six figures, which is why many landlords start planning the exit well before listing the property.

Washington has no state income tax, and its capital gains excise tax, which applies to certain long-term investment gains above an indexed threshold, explicitly does not apply to real estate sales. A landlord in Yakima or the Tri-Cities selling a rental is not adding a state real estate gains tax to the federal bill, though other holding costs, such as the state's real estate excise tax charged on the sale itself, are a separate line item unrelated to income tax and apply regardless of gain or loss.

A few decisions made ahead of a sale can materially change the after-tax proceeds. An installment sale spreads recognition of the gain across the years payments arrive, which can keep the seller in a lower bracket in any single year. Pairing the sale with capital losses harvested elsewhere in the same tax year can offset part of the gain. And for owners who intend to remain invested in real estate, a 1031 exchange defers both the recapture and the appreciation gain by rolling net proceeds into a replacement property, rather than paying either tax at closing.

The exchange requires the relinquished property to have been held for investment or business use, which a long-term rental satisfies, and it requires equal or greater value and debt in the replacement property to defer the full gain. A landlord selling a single-family rental in Kent for 400,000 dollars in equity, for instance, would generally need to acquire replacement property with at least that much equity, and generally at least the sale price in total value, to avoid recognizing any taxable boot on the exchange.

Because the 45-day identification clock starts at closing on the relinquished property, landlords who wait until after the sale to start thinking about a 1031 exchange often run out of runway to line up a qualified intermediary and locate replacement candidates. The more workable pattern is deciding on the tax strategy, sell outright, install a payment plan, or exchange, before the property goes on the market, so the closing documents and any exchange agreement can be coordinated from the start rather than patched together under deadline pressure.