Tax Implications of Selling a Rental Property: What Landlords Need to Know

by Stephen Morris CPA, MBT, CCIM

Selling a rental property can be a lucrative move, but it also comes with tax consequences that landlords and real estate investors need to plan for. We provide CPA services for landlords and in this article wish to increase your understanding of capital gains tax, depreciation recapture, and strategies for tax deferral which can help you minimize your tax liability and maximize your profits.

Here’s what you need to know before selling your rental property and how to strategically manage your taxes for the best financial outcome.

🏠 Key Tax Considerations When Selling a Rental Property

📊 1. Capital Gains Tax on Rental Property Sales

When you sell a rental property for more than you paid, the profit (gain) is subject to capital gains tax (CGT).

📌 Short-Term vs. Long-Term Capital Gains:
✔️ Short-term gains (if held for less than a year) are taxed at ordinary income tax rates (10%–37%).
✔️ Long-term gains (if held for more than a year) qualify for lower tax rates (0%, 15%, or 20%).

💡 Pro Tip: Holding a property for at least a year before selling can significantly reduce your tax bill by qualifying for long-term capital gains tax rates.

🔄 2. Depreciation Recapture Tax

Depreciation is a great tax benefit when you own rental properties, but when you sell, the IRS requires you to recapture the depreciation deductions you’ve taken over the years.

📌 How It Works:
✔️ The IRS taxes recaptured depreciation at a fixed 25% rate (not capital gains rates).
✔️ The more depreciation you’ve claimed, the higher your recapture tax bill.
✔️ Depreciation recapture applies even if you never deducted depreciation on your tax return—you’re taxed as if you did.

💡 Example:

• Purchased rental property for $300,000 (building worth $250,000 after subtracting land value).
• Depreciated the building by $50,000 over 10 years.
• Sell the property for $400,000.
• $50,000 of the gain is taxed at 25% (depreciation recapture).
• The remaining gain ($100,000) is taxed at capital gains rates (0%, 15%, or 20%).

🚀 How to Reduce Taxes When Selling a Rental Property

🔁 1. Use a 1031 Exchange to Defer Taxes

A 1031 exchange lets you defer capital gains and depreciation recapture taxes if you reinvest the proceeds into another rental or investment property.

📌 1031 Exchange Rules:
✔️ The replacement property must be “like-kind” (another rental or investment property).
✔️ You must identify a replacement property within 45 days and close within 180 days.
✔️ All sale proceeds must be reinvested to fully defer taxes.

💡 Pro Tip: A 1031 exchange allows investors to continually defer taxes and build larger real estate portfolios over time.

🏡 2. Convert the Rental Into a Primary Residence

If you’ve lived in the property for at least 2 of the past 5 years, you may qualify for the Section 121 Exclusion, which allows:

✔️ Single filers to exclude up to $250,000 in capital gains.
✔️ Married couples to exclude up to $500,000 in capital gains.

📌 Important Considerations:

• Depreciation recapture still applies (even if you qualify for the exclusion).
• Time as a rental reduces the exclusion percentage.

💡 Best For: Landlords looking to sell a rental and transition into homeownership.

💰 3. Offset Gains With Capital Losses

If you have capital losses from other investments, they can be used to offset rental property capital gains.

📌 How It Works:
✔️ Long-term capital losses offset long-term gains (same for short-term).
✔️ You can carry forward unused losses to future tax years.

💡 Best For: Investors with losses from stocks, real estate, or other investments.

🏦 4. Structure the Sale as an Installment Sale

Instead of selling the property for a lump sum, an installment sale spreads the gain over several years, reducing your annual tax burden.

📌 Benefits:
✔️ Taxes on capital gains are spread over multiple years.
✔️ Lower tax brackets may apply each year, reducing the overall tax rate.

💡 Best For: Landlords selling high-value properties and looking to manage annual tax exposure.

📜 5. Consider Opportunity Zone Investments

Selling your rental and reinvesting in a Qualified Opportunity Zone (QOZ) allows you to defer and reduce capital gains taxes.

📌 Benefits:
✔️ Defers capital gains tax until 2026.
✔️ Potential tax-free appreciation if held for 10+ years.

💡 Best For: Investors wanting long-term tax-free real estate appreciation.

📋 Tax Reporting When Selling a Rental Property

📝 IRS Forms You’ll Need:

✔️ Form 4797 – Reports the sale of rental property.
✔️ Schedule D – Reports capital gains and losses.
✔️ Form 6252 – If using an installment sale.
✔️ Form 8824 – If completing a 1031 exchange.

💡 Pro Tip: Keep detailed records of purchase price, improvements, depreciation, and expenses to calculate your tax liability correctly.

🔥 Final Thoughts: Tax Implications of Selling a Rental Property

Selling a rental property comes with tax implications that can significantly impact profits. Understanding capital gains tax, depreciation recapture, and tax-deferral strategies can help landlords reduce tax liability and maximize returns.

✅ Key Takeaways:

✔️ Long-term capital gains tax is lower than short-term (hold properties at least a year).
✔️ Depreciation recapture tax applies when selling (25% tax rate).
✔️ Use a 1031 exchange to defer taxes and reinvest in new properties.
✔️ Convert the rental to a primary residence to qualify for capital gains exclusions.
✔️ Offset gains with capital losses or use an installment sale to spread taxes over time.
✔️ File the correct IRS forms and maintain detailed transaction records.

Planning ahead with the right tax strategy ensures that you keep more profits in your pocket and make the most of your real estate investments.

Back to Advise RE Resource Center articles list

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