Why a rental sale is taxed differently from a home sale
When you sell a rental building held for more than a year, your profit is generally a long-term capital gain. Two features make it more involved than selling a primary residence. First, the home-sale exclusion does not apply. Second, every year you owned the building you were entitled to deduct depreciation, and that depreciation lowers your basis. At sale, the portion of your gain that comes from depreciation is taxed separately, at a federal rate of up to 25%.
The rest of the gain is taxed at the long-term capital gains rate of 0%, 15% or 20%, depending on your taxable income. Higher earners may also owe the 3.8% net investment income tax, and most states tax the gain as well.
How the calculator works
Each output builds on the one before it:
- Adjusted basis = original purchase price + capital improvements − depreciation taken.
- Total gain = sale price − selling costs − adjusted basis.
- Depreciation recapture = the smaller of depreciation taken or total gain, taxed at up to 25% federally.
- Remaining capital gain = total gain − depreciation recapture, taxed at the federal rate you select (0%, 15% or 20%).
- NIIT, if switched on, adds 3.8% of the total gain. State tax applies your state rate to the total gain.
- Net proceeds before debt payoff = sale price − selling costs − estimated federal and state tax.
A worked example
An owner bought a building for $1,000,000, spent $200,000 on capital improvements and has taken $400,000 in depreciation. Adjusted basis is $800,000. The building sells for $2,000,000 with $100,000 in selling costs, so the total gain is $1,100,000.
Of that, $400,000 is depreciation recapture; at 25% that is $100,000. The remaining $700,000 at 20% is $140,000. NIIT at 3.8% on $1,100,000 adds $41,800, and a 5% state rate adds $55,000. Estimated tax totals $336,800, leaving about $1,563,200 before paying off any mortgage.
Ways sellers defer or spread the tax
A 1031 exchange lets you defer federal capital gains and recapture tax by reinvesting the proceeds into like-kind real property. You identify replacement property within 45 days of closing and complete the purchase within 180 days, with a qualified intermediary holding the funds in between. Skyline can accommodate 1031 timing, including a delayed closing to line up with your exchange.
An installment sale, such as a seller-financed deal, spreads recognition of the gain over the years you receive principal payments rather than taxing it all in the year of sale. Skyline offers seller-carry structures when they fit the deal. How recapture is handled in an installment sale has its own rules, so review the structure with your CPA before you sign.
Common mistakes
These errors are the usual reasons an estimate misses by a wide margin.
- Leaving out depreciation because you never claimed it. The IRS generally computes recapture on depreciation that was allowable, whether or not you took it.
- Counting repairs as capital improvements. Only improvements that added value or extended the building’s life belong in basis.
- Forgetting acquisition closing costs, which usually add to your original basis.
- Treating net proceeds as cash in hand. Your mortgage payoff still comes out of the figure shown.
- Using the wrong state rate, or forgetting that some states tax capital gains as ordinary income.
