Capital Gains Tax & Depreciation Recapture on a Property Sale

Start with adjusted basis

Before you can understand the tax, you need to understand adjusted basis — the number the IRS measures your gain against.

• ›You start with what you paid (purchase price plus certain acquisition costs).
• ›You add capital improvements (a new roof, an addition).
• ›You subtract the depreciation you took (or could have taken) over the years.

That last subtraction is what drives the surprise tax bill. Depreciation lowers your basis, which increases your taxable gain when you sell — and a chunk of that gain gets taxed at a higher recapture rate.

This is educational only and not tax advice — your CPA can model your specific numbers.

The capital gains layer

When you sell investment real estate for more than your adjusted basis, the profit is a capital gain.

If you held the property more than a year, it's a long-term gain, taxed at federal rates of 0%, 15%, or 20% depending on your taxable income. Hold for a year or less and it's a short-term gain, taxed at ordinary income rates — generally a bad outcome. Add state income tax, which ranges from zero to north of 13% depending on where you (or the property) sit, and the combined bite grows.

Capital gains are only the first layer. The one that catches people off guard is recapture.

Depreciation recapture

Each year you owned the rental, you likely deducted depreciation — for residential rentals, roughly 1/27.5 of the building's value per year — lowering your taxable income along the way. When you sell, the IRS "recaptures" the benefit of those deductions.

This unrecaptured Section 1250 gain is taxed at a federal rate of up to 25% — often higher than your long-term capital gains rate. Two important nuances:

• ›It applies whether or not you actually claimed the depreciation. The IRS uses "allowed or allowable," so if you forgot to take depreciation, you can still owe recapture on it. (Don't skip depreciation hoping to avoid recapture — it doesn't work, and you lose the deductions too.)
• ›Recapture is generally taxed before the lower-rate capital gain, so it tends to come off the top.

For long-held properties, recapture alone can be a very large number, because you may have decades of deductions to unwind.

The 3.8% net investment income tax

Higher-income investors face an extra layer: the net investment income tax (NIIT) of 3.8%, which applies to net investment income — including capital gains — above certain modified adjusted gross income thresholds.

A property sale can spike your income for the year, pushing you over those thresholds even if you're normally below them. Stacked on top of capital gains and recapture, this surtax pushes the total tax on a big sale even higher.

A worked example

Illustrative figures, not a quote for your situation:

• ›Original purchase: $400,000
• ›Depreciation taken over the years: $120,000
• ›Adjusted basis: $280,000
• ›Sale price: $700,000
• ›Total realized gain: $420,000

That gain splits into two buckets:

• ›$120,000 of unrecaptured Section 1250 gain, taxed at up to 25% → up to $30,000.
• ›$300,000 of remaining long-term capital gain, taxed at (say) 15–20% → roughly $45,000–$60,000.
• ›Plus possible 3.8% NIIT and state tax on top.

Combined, the total federal-plus-state hit could easily exceed $90,000–$120,000 on this sale. That's money leaving your investment permanently in a taxable sale.

Adding up the layers

A simplified, illustrative picture of a fully taxable sale stacks:

• ›15% to 20% federal long-term capital gains tax.
• ›Up to 25% depreciation recapture (on the recapture portion).
• ›3.8% NIIT for higher earners.
• ›State income tax, depending on where you live or where the property sits.

Combined, an investor can lose a meaningful share of the sale to taxes. (Figures are general and illustrative — your actual rate depends on your income, holding period, state, and depreciation history.)

How a 1031 changes the math

A 1031 exchange lets you defer all of these layers at once — capital gains, depreciation recapture, and NIIT — by reinvesting into like-kind investment real estate.

Instead of writing a six-figure check to the IRS, you keep the full amount working in your next investment. Using the example above, that's potentially $90,000+ still compounding for you rather than gone. Over multiple exchanges, the difference between repeatedly paying tax and repeatedly deferring can be enormous.

The stepped-up basis endgame

Here's why long-term investors call it "swap till you drop." When you hold property until death, your heirs generally receive a stepped-up basis equal to the property's fair market value at that time. The deferred capital gain and recapture that built up over your lifetime can be wiped out for your heirs — they inherit at the current value and could sell with little or no gain.

This is the most powerful outcome of long-term 1031 strategy: deferral that can become permanent forgiveness at the next generation. (Estate tax and other rules still apply — coordinate with an estate attorney.)

What this means for you

The tax you'd owe on a sale is bigger than most investors assume, because recapture and NIIT pile on top of the headline capital gains rate. Before you sell, have your CPA model the full stack — all four layers — so you see exactly what's at risk. Then weigh that number against a 1031 exchange, which lets you keep every one of those dollars invested and, held long enough, potentially erase the gain entirely through a stepped-up basis.