Tax Considerations When Selling a Rental Property
What real estate investors should understand about adjusted basis, depreciation, capital gains, depreciation-related tax consequences, and §1031 exchanges before selling.
The Tax Calculation Starts Long Before the Closing Date
Selling a rental property can produce a substantial cash gain, but the amount deposited into your bank account is not necessarily the amount subject to tax.
The tax analysis generally begins with the property's adjusted tax basis.
A simplified calculation looks like:
- **Original Basis
- Capital Improvements
- − Depreciation
- = Adjusted Basis**
The gain is then generally determined by comparing the amount realized from the sale with the property's adjusted basis.
Depreciation Matters at Sale
Depreciation reduces the property's tax basis while you own it. As a result, depreciation claimed—or in some cases depreciation that should have been claimed—can affect the taxable gain when the property is sold.
This surprises many property owners who focus only on:
Purchase Price vs. Selling Price
without considering years of depreciation and other basis adjustments.
Capital Improvements Can Increase Basis
Proper records are extremely important.
Qualifying capital improvements may increase basis, potentially reducing taxable gain.
Examples might include:
- Major renovations
- Additions
- New roofs
- Significant building systems
- Other qualifying capital improvements
This is why investors should retain purchase documents, settlement statements, improvement records, depreciation schedules, and sales documents.
Depreciation Recapture
The tax treatment of a rental property sale can involve more than one category of gain.
Depreciation-related rules may cause part of the gain to receive different tax treatment from the remaining gain. The IRS requires taxpayers to maintain records needed to calculate depreciation recapture and other gain on disposition.
What About a 1031 Exchange?
A qualifying IRC §1031 like-kind exchange may allow an investor to defer recognition of certain gains when investment or business real property is exchanged for qualifying real property.
The rules are highly procedural, so planning should occur before the sale closes, not after the proceeds have already been received.
Plan Before You Sell
Before listing or closing on a rental property, investors should understand:
Expected Sale Price → Adjusted Basis → Estimated Gain → Depreciation Effects → Estimated Tax → Net Cash After Tax
At Akato & Associates, we help real estate investors evaluate the tax consequences of a sale before the transaction is completed.
This material is provided for general information only and does not constitute accounting, tax or legal advice. It does not take account of your particular circumstances. Contact the firm before acting on anything you read here.