Selling a Rental Property: What It Really Costs in Tax

Why the answer isn’t just “15%”

Many landlords expect a rental sale to be taxed at a flat capital gains rate. In practice the gain is taxed in layers, and a large sale changes how your other income is taxed. That’s why two sellers with the same gain can owe very different amounts.

Step 1: figure the gain

Gain is the sale price, less selling costs, less your adjusted basis. Adjusted basis is what you paid, plus improvements, minus the depreciation you claimed or were entitled to claim. That last part surprises people: depreciation reduces your basis even if you never deducted it on a return.

Step 2: the layers of tax

• Depreciation recapture (“unrecaptured Section 1250 gain”). The part of the gain equal to depreciation is taxed at your ordinary rate, capped at 25%.
• Long-term capital gain. The remaining gain is taxed at 0%, 15%, or 20%, depending on your total taxable income.
• Net investment income tax. An extra 3.8% applies to the lesser of your investment income or the amount your income exceeds $200,000 (single) or $250,000 (married filing jointly). These thresholds aren’t adjusted for inflation.
• Suspended passive losses. Rental losses you couldn’t deduct in earlier years are released when you sell the whole property, which can lower the net cost.
• Colorado tax. Colorado taxes capital gains as ordinary income at its flat rate.

Step 3: the ripple effects

A large gain raises your adjusted gross income, which can reduce or eliminate deductions and credits that phase out with income, increase the taxable part of Social Security benefits, and raise Medicare premiums (IRMAA) two years later. It can also push your wages or retirement income into a higher bracket.

The tax impact analysis

Because of all these interactions, the only dependable way to measure the cost of a sale is to prepare your return twice: once without the sale and once with it. The difference is the true cost of selling. Two examples from our files:

These examples were calculated under the tax rates in effect at the time and are shown for illustration.

What else to weigh

• Market timing and what you would do with the cash
• Alternatives to a sale: a 1031 exchange, an installment sale, or holding the property for heirs, who generally receive a stepped-up basis
• Whether the property was once your home (see combining the home-sale exclusion with a 1031 exchange)
• The time and headaches of being a landlord

What we need to run the numbers

• Your most recent tax return, including the depreciation schedule and any carried-over passive losses
• Property purchase and improvement records
• Current-year rental income and expenses
• The projected sale price and selling costs
• An estimate of your other income for the year of the sale

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