What is the Capital Gain on Rental Property

Selling a rental property is going to cost you much more in capital gains tax than selling a personal-use property. The methods for calculating the tax on both types of property sales are similar.

Capital Gain Definition
Capital gain is defined as the amount by which the selling price of an asset exceeds the purchase price; the gain is realized when the asset is sold.

Calculating Gain or Loss on Rental Property

To determine the gain or loss on the sale of your rental property, you need to determine the selling price, the adjusted basis, plus subsequent capital improvements, and minus depreciation.

Capital gain on rental property example: Brett purchased a residential property 5 years ago for $200,000. He plans on selling it now for it’s current fair market value of $475,000. Brett has taken an annual depreciation expense of $5,400 resulting in a total of $27,000 ($5,400 x 5 years). Over the same time he made improvements to his rental property at a cost of $10,000. His costs associated with the sale of the property are $10,000. The taxable gain on the sale of his rental property is determined as follows:

Adjusted Basis
Original Cost$ 200,000
Improvements$ 10,000
Depreciation$( 27,000)
Adjusted basis $ 183,000
Taxable Gain
Sales price $ 475,000
Adjusted basis$(183,000)
Selling costs$( 10,000)
Taxable Gain$ 282,000

Brett’s taxable gain of $282,000 will be taxed at two different rates, one for the depreciation amount of $27,000 and the other for the remainder of the gain $255,000 ($282,000 – $27,000).

Since Brett took a depreciation deduction during the time he owned the rental property, he would need to recapture the cost. Under current law, depreciation recapture is taxed at a maximum federal tax rate of 25%. Brett will owe $6,750 due to the depreciation ($27,000 x 25%).

The remainder of his gain, $255,000, will be taxed at whatever capital gain tax rate applies to him. Let’s assume Brett has a capital gain tax rate of 20%. He will owe $51,000 in taxes on the remainder of his gain ($255,000 x 20%).

Thus, Brett’s total federal taxes due will be $57,750 ($51,000 + $6,750).

Capital Gains Related to State Taxes
Note that state taxes may also be due in addition to federal taxes. States may have different rulings for taxing capital gains. Before you sell your rental property, you should understand the state tax rules. If your property is located in a state other than your primary residence, it would be smart to learn the rules of both the state of your residence and the state your rental property resides in. Both states may have a vested interest in your taxable gain. When in doubt, consult an accountant or tax attorney. If your sale results in a loss, the entire loss can offset income from other sources.

Tax Free Exchange of Like-Kind Property
Is there a way around paying taxes when you sell your rental property? You bet there is!

The Starker 1031 Tax-Deferred Exchange allows you to avoid paying taxes on the gain on the sale of your home.