Capital gains are a complex component of owning or investing in a rental property.
If you’re not careful, you may face a big tax hit when you sell.
Capital gains taxes — and other hidden obligations like depreciation recapture — can take a significant bite out of your profits.
But they don’t have to.
There are proven, legal strategies to reduce or even avoid taxes on your rental property.
And planning effectively will let you keep more of your investment returns.
You just need to understand how capital gains taxes work and the key steps you can take to reduce your liability.
All while ensuring you avoid common mistakes made by other rental property owners.
Sound complicated?
Not with a little guidance.
Here’s everything you need to know about minimizing capital gains taxes on a rental property.
What are capital gains taxes on a rental property?
Capital gains taxes on your rental property are the dues you pay on any profits you earn when selling.
This is similar to selling other investments, where profits above the original cost are subject to taxes.
You may owe capital gains taxes if you sell your rental property for more than its adjusted cost basis, which includes adjustments for improvements and depreciation.
How much?
That depends first and foremost on how long you’ve owned the property.
That’s because the IRS assigns different tax rates based on two types of capital gains:
- Short-term capital gains apply to rental properties you’ve owned for less than a year. They’re taxed at your ordinary income tax rate, which ranges from 10% to 37% depending on your tax bracket.
- Long-term capital gains apply to properties you’ve owned for a year or more. These are taxed at lower rates of 0%, 15%, or 20% based on your total income.
Depreciation recapture: The hidden tax to plan for
Capital gains aren’t the only form of real estate investment taxation.
A sneaky tax known as depreciation recapture can also diminish the profits on the sale of your rental property if you aren’t prepared.
What is depreciation recapture?
Depreciation recapture is the IRS’s method of taxing the portion of your rental property’s sale proceeds that were reduced (or could have been reduced) through depreciation deductions during ownership.
Here’s how it works…
When you own a rental property, you can deduct 3.636% of the building’s value (excluding the land) annually.
These deductions lower your taxable income and reduce your annual tax liability.
The catch?
When you sell the property, the IRS reclaims part of these tax benefits through depreciation recapture.
This portion of your sale proceeds is taxed as ordinary income, at a maximum rate of 25%, even if you didn’t claim the depreciation.
While the calculations can get complex, here’s the big picture:
You may face a higher tax bill on this portion of your profits.
But there are strategies to minimize the impact of depreciation recapture (as we’ll explore below).
How to calculate capital gains tax on a rental property
Capital gains and depreciation recapture are the two primary taxable components of selling a rental property.
Calculating both is crucial for understanding your potential tax liability.
These calculations can be complex, but a clear step-by-step process will help you determine the total tax implications.
And they can help you uncover opportunities to minimize your liability.
Here are the steps to calculating taxes on a rental property.
Determine the adjusted cost basis
The first step in calculating your taxes from selling a rental is to determine your “adjusted cost basis.”
The adjusted cost basis reflects what you originally paid for the property, plus additional related costs, minus any depreciation and deductions.
Here’s how to calculate it using an example of a home purchased for $200,000 and owned for 10 years:
- Original purchase price: $200,000 (with $160,000 attributed to the building value)
- Add selling costs: $25,000 (agent commissions, escrow fees, title fees, etc.)
- Add property improvements: $50,000 (major updates or renovations, excluding regular maintenance)
- Subtract depreciation claimed: $58,180 (3.636% of $160,000 per year for 10 years)
Total adjusted cost basis: $216,820
Calculate the realized gain
To determine your total capital gains on the sale of a rental property, the IRS subtracts your adjusted cost basis from the sale price.
Using the example above, if the property sells for $400,000, your realized gain would be:
$183,180 = $400,000 (sale price) – $216,820 (adjusted cost basis).
The realized gain represents your total profit from the sale after accounting for all costs and deductions.
As shown in this example, expenses like selling costs and property improvements significantly reduce the taxable income.
This is why a higher adjusted cost basis can be a significant advantage for rental property owners.
Separate profits into depreciation recapture and capital gains
Your realized gain isn’t fully taxed as capital gains.
The IRS separates it into two components: depreciation recapture (unrecaptured gains) and capital gains.
Here’s how it breaks down using the example property:
- Unrecaptured gains: $58,180
- Taxed as ordinary income, capped at 25%
- Capital gains: $125,000
- Calculated as $183,180 (realized gain) – $58,180 (depreciation)
- Taxed at your long-term capital gains rate of 0%, 15%, or 20%, depending on your taxable income
Keep in mind that this split between capital gains and unrecaptured gains happens even if you didn’t claim the depreciation earlier.
So you should always account for depreciation in your tax planning when selling your rental.
Account for state taxes
Before you total up the CGT on your rental property, you should also consider any state-specific capital gains taxes.
State capital gains tax rates vary widely, so knowing the laws in your area is critical.
For instance, the top marginal tax rate on capital gains in North Dakota is only 1.5%.
But in Hawaii, it’s 7.25% — a big tax difference if you’re trying to sell your vacation home on the beach on O’ahu.
Some local tax authorities simply treat long-term capital gains as ordinary income.
That means no extra taxes in states like Texas or Florida, but a top rate of 13.3% in California or 10.9% in New York.
You get the idea.
Where you live makes a big difference when calculating capital gains on the proceeds from the sale of a house that was a rental.
Calculate your total tax liability
Now, let’s bring everything together to help you estimate your tax obligation in any scenario.
Here’s how to calculate the potential tax implications on the same $400,000 sale for someone in the top tax bracket in California:
- Unrecaptured gains tax: $14,545 (25% of $58,180)
- Capital gains tax: $25,000 (20% of $125,000)
- California state income tax: $24,363 (13.3% of total gain of $183,180)
- Note: California taxes the entire gain — including capital gains and depreciation recapture — at the state’s ordinary income tax rates, with no distinction between the two.
Total tax liability: $63,908
Someone who sold that same rental property in Texas would only owe $39,545 in federal capital gains taxes.
The point?
Knowing how to estimate your adjusted basis, depreciation, and federal and state capital gains makes a huge difference in your planning.
How to minimize your capital gains taxes on rental property
The right strategies can help you reduce or defer your tax liability, depending on your circumstances.
You can even avoid capital gains taxes on your rental with careful planning.
Here are six effective ways to minimize or avoid capital gains taxes on a rental property.
1. Hold the property for long-term gains
One of the simplest ways to reduce your tax liability on an investment property is to hold onto it a bit longer.
Why?
Long-term capital gains taxes are far more favorable, with rates topping out at 20%, compared to 37% for short-term gains.
For example, let’s say you’re in the top tax bracket and buy a property in a hot market.
You then rack up $50,000 in capital gains in just eight months, and you’re eager to cash in.
However, selling immediately would result in a tax bill of $18,500 (37% of $50,000) due to short-term capital gains taxes.
Now imagine waiting just four more months.
You’d owe only $10,000 (20% of $50,000) — an $8,500 savings.
The math is simple: owning the property for at least 12 months automatically qualifies you for lower tax rates, making it an easy way to reduce your liability.
2. Avoid taxes with the primary residence exclusion
One of the best ways to sell a rental property without paying taxes is to make it your home first.
You can do this through what the IRS calls the primary residence or Section 121 exclusion.
The primary residence exclusion allows you to deduct up to $250,000 in capital gains ($500,000 for married filing jointly) on your primary home.
But you can’t just move in and then turn around and sell the property — you’ll have to pass the ownership and use tests.
The IRS requires you to meet both of the following qualifications in the same five-year period:
- Own the home for two years.
- Live in the home for two years.
Those two-year periods can happen simultaneously, but they don’t have to.
You just need to pass both tests in the same five-year timeframe to avoid or limit capital gains.
What does this mean for your rental property?
All you have to do is move in and live there for at least two years — or even less if you previously lived there.
For instance, say you’re selling an Airbnb property you’ve owned for four years.
You lived there in the first of those four years, then rented it out for three.
Moving back in for one more year would qualify you for the primary residence exclusion.
3. Defer taxes through a 1031 exchange
You can easily avoid paying federal capital gains taxes when selling a rental home if you plan to continue investing in rental properties.
The IRS allows this through a 1031 exchange, which is named after Section 1031 of the Internal Revenue Code.
This process allows you to defer capital gains taxes by reinvesting the proceeds in another “like-kind” property.
What exactly does that mean?
The IRS says properties are like-kind if they’re of the “same nature or character, even if they differ in grade or quality.”
That means most rental properties are inherently like-kind as long as they’re located in the U.S.
You can qualify for a like-kind exchange even if you sell a multi-family property and buy a single-family home.
Or swap a luxury rental for a fixer-upper.
But you should be aware of some important requirements:
- Both properties must be for business purposes. In other words, you can’t sell your rental property to buy a new home for yourself and get the tax benefits.
- You usually must use a qualified intermediary. This neutral third party holds the funds during the exchange process to ensure compliance with IRS rules.
- Time is limited. You must identify up to three potential properties to buy within 45 days and close on the purchase within 180 days of your original sale.
- Aim for equal or greater value. The new property and associated mortgage should be equal to or greater than your previous one to defer all capital gains.
You may be able to dodge capital gains taxes on your rental property if you meet these qualifications.
4. Reinvest in an Opportunity Zone
What if you don’t want to reinvest the entire proceeds from the sale of your property?
There’s still a way to defer capital gains taxes.
You can reinvest just the capital gains portion into an “Opportunity Zone.”
Opportunity Zones are designated distressed areas where the government offers tax incentives to encourage investments that spur economic growth.
Compared to a 1031 exchange, the rules for Opportunity Zones are more flexible.
To qualify, you only need to reinvest the capital gains, not the entire property sale proceeds.
But you must invest in a Qualified Opportunity Fund to take advantage of this tax reduction strategy.
There are other rules that apply when using Opportunity Zones for tax breaks.
So be sure to consult a tax professional for guidance.
5. Offset gains with losses from other investments
Do you own other assets besides your rental property?
If so, you may be able to reduce your capital gains taxes through a process called tax-loss harvesting.
Here’s how it works:
Tax-loss harvesting involves selling underperforming investments at a loss to offset the gains from your rental property sale.
The goal isn’t to intentionally lose money but to make the most of any existing losses in your portfolio.
For example:
- If your rental property sells with a $100,000 capital gain and you sell shares in Company X at a $25,000 loss, you’ll only pay taxes on $75,000 in gains rather than the full $100,000.
This strategy can help you reduce your total tax liability by turning a bad investment into a tax-saving opportunity.
Don’t have any poor-performing assets?
- You can still lower your taxable income by timing the sale of your rental property during a low-income year or when you’re taking significant deductions for business losses, charitable contributions, or medical expenses.
6. Use installment sales to defer proceeds and taxes
An installment sale allows you to finance the sale of your rental property by receiving payments over time rather than in a lump sum.
This approach spreads your proceeds — and the associated taxes — across multiple years, potentially reducing your immediate tax liability and keeping you in a lower tax bracket.
How it works:
- You sell the property, taking a down payment up front.
- The buyer agrees to pay the remaining balance in installments over a set period, with interest.
- Taxes on the capital gains are applied only to the portion of proceeds received each year.
Example calculation:
If you sell a property for $400,000 with a $50,000 down payment and a seven-year repayment plan of $50,000 annually:
- Gross profit percentage: $130,000 (profit) ÷ $400,000 (sale price) = 32.5%
- Taxable capital gains per payment: 32.5% of each $50,000 installment, or $16,250 per payment
This strategy can defer taxes and provide a steady income stream, but there are caveats:
- Depreciation recapture: You’ll pay taxes on depreciation as ordinary income at the time of sale.
- Interest taxation: Interest on payments is taxed as ordinary income.
- Buyer risk: If the buyer defaults, you may not receive the full amount.
While installment sales aren’t ideal if you need immediate cash, they can effectively reduce your tax burden over time.
As always, consult a tax professional to determine if this strategy is right for you.
Mistakes to avoid when managing capital gains taxes
Sidestepping capital gains taxes on a sold rental property is possible.
But finding the best approach can be complicated, and it’s easy to get lost in the tax rules.
Here are three big (but common) mistakes to watch for when trying to reduce your capital gains.
Failing to account for depreciation recapture
Depreciation recapture is an especially confusing — and often overlooked — aspect of capital gains tax rules for rental properties.
Many investors don’t realize the IRS will reclaim taxes on these previous deductions.
Some don’t even take the deductions at all and are blindsided by these taxes as a result.
Plus, the tax rate for depreciation recapture is higher than capital gains rates.
It also applies even in situations where capital gains taxes don’t, like installment sales.
The reality?
Depreciation adds up and applies to the original purchase price plus any improvements you make.
The write-offs are a huge help for reducing your tax liability while you own the property, but they can bite you when it comes time to sell.
So be sure you plan for the potential impact of depreciation recapture when you offload your rental.
Missing deadlines for a 1031 exchange
A 1031 exchange is one of the best ways to avoid capital gains taxes on rental properties.
But the clock starts ticking as soon as you complete the sale.
You only have 45 days to identify potential properties and 180 days to finalize your next purchase.
Those timelines are concurrent, so the 45 days are part of the total 180.
And they include weekends and holidays, not just business days.
So don’t sit back and wait to find a new place to invest those funds — get started before you complete the sale of your rental property.
Be sure to select multiple like-kind properties in case the sale on your first choice falls through.
You may also need to file a tax extension if the 180 days extend past the tax filing deadline for the year.
Otherwise, taxes on the sale will be due before you complete the like-kind exchange.
Not consulting a tax professional
A crucial mistake when trying to steer clear of capital gains taxes on your rental?
Trying to figure it all out on your own.
Tax professionals know the ins and outs of capital gains rules.
They understand the nuances of 1031 exchanges, primary residence exclusions, and tax-loss harvesting.
And they’ll know how to sort out the implications of depreciation recapture.
The bottom line?
Working with an experienced professional will help you find the right strategy for your situation.
Next steps to reduce your tax liability
Capital gains are a sign of a profitable rental property investment.
But they can also translate to a big tax hit.
Planning ahead can ensure you find the best ways to reduce or even avoid capital gains taxes on the sale of your rental property.
Explore strategies such as delaying the sale, making a like-kind exchange, or converting the property to your primary residence to minimize your tax liability.
Watch out for depreciation recapture, and be sure you know the tax rules and deadlines — both federally and in your state.
And be sure to consult a tax professional to point you in the right direction.
For more guidance on the sales process, check out our guide to selling a rental property.
