Taxes When Selling Rental Property (2026)

Selling a rental property feels like cashing in — until you see the tax bill. Unlike selling stocks, rental property can trigger up to four separate federal taxes at the same time, stacking rates that can add up to 40–60% on some of the gain. This guide explains every layer, gives you the 2026 numbers, and walks through a complete worked example.

The four federal taxes at a glance

Every dollar of gain from a rental sale gets sorted into one or more of these categories. They're not mutually exclusive — NIIT stacks on top of the others for passive investors.

What determines your adjusted basis (and why it matters)

Your gain isn't calculated from the purchase price — it's calculated from your adjusted basis, which is your purchase price minus all depreciation you've taken (or were required to take). Every year you hold a rental property, depreciation reduces your basis whether you claim it or not. Failing to take depreciation doesn't protect you from recapture at sale — the IRS recaptures "allowed or allowable" depreciation under IRC § 1250(b).

If you've owned a rental for 10 years and depreciated a $400,000 structure at $14,545/year (27.5-yr schedule), you've reduced your basis by $145,450 — and you owe recapture tax on that entire amount when you sell, regardless of what the property is worth today.

Layer 1: §1245 recapture — ordinary income on cost seg components

If you did a cost segregation study and took 100% bonus depreciation on 5-year and 7-year components, those deductions are recaptured as ordinary income the year you sell — not at the favorable 25% cap that applies to the building structure.¹

At a 37% marginal rate, every $100,000 of cost seg depreciation you've taken creates $37,000 of tax at sale. The only way to defer §1245 recapture is via a 1031 exchange (which rolls it into the replacement property's basis) or the step-up in basis at death under IRC § 1014 (which eliminates it entirely).

If you haven't done cost segregation: §1245 recapture is zero or minimal, because straight-line depreciation on the building structure is §1250, not §1245. Most residential rental investors without a cost seg study skip Layer 1 entirely.

Layer 2: §1250 unrecaptured gain — up to 25% on building depreciation

The depreciation you've taken on the building structure — 27.5 years for residential, 39 years for commercial — is recaptured as "unrecaptured §1250 gain." This is still taxed as ordinary income in theory, but IRC § 1(h)(1)(D) caps the rate at 25%.²

This layer applies to almost every rental property sale. If you've owned a $400,000 residential rental building for 10 years and depreciated $14,545/year, you have $145,450 of unrecaptured §1250 gain taxed at up to 25% — regardless of what the property sold for.

Layer 3: Long-term capital gains — appreciation above original cost

After subtracting §1245 and §1250 recapture amounts from your total gain, the remaining gain is taxed at preferential long-term capital gains rates — but only if you've held the property more than one year.

2026 LTCG thresholds (single filers):³

These thresholds are based on taxable income — including the gain itself. A large property sale can push you from the 15% bracket into the 20% bracket, or push you over the NIIT threshold even if you were below it before.

Layer 4: Net investment income tax (NIIT) — 3.8% surtax for passive investors

The NIIT applies to the lesser of your net investment income (NII) or the amount by which your MAGI exceeds the threshold.⁴ For 2026, those thresholds are $200,000 for single filers and $250,000 for married filing jointly — and they are not adjusted for inflation.

For passive rental investors (i.e., anyone who doesn't qualify as a Real Estate Professional under IRC § 469(c)(7)), the entire gain from a rental sale counts as NII. The NIIT stacks on top of §1250 recapture, LTCG, and §1245 recapture — it's an additional 3.8% on all of it.

The full stack for passive rental investors

Most investors are passive with respect to their rentals. If you are, here's how the four layers combine on a single property sale:

State income taxes add another 0–13% depending on where the property is located — California and New York investors face particularly high combined effective rates.

PAL carryforward release at sale

There's one item that can reduce your net taxable gain: accumulated passive activity loss (PAL) carryforwards. Under IRC § 469(g), when you fully dispose of a passive activity, all suspended PAL carryforwards are released in the year of sale and can be used against the gain — even if you normally can't touch them.

Example: you've had a rental property suspended as passive for 8 years, accumulating $60,000 in PAL carryforwards from depreciation losses you couldn't use. When you sell, that $60,000 offsets your gain, reducing your tax bill directly. At the 28.8% combined rate (§1250 + NIIT), that's about $17,280 of federal tax saved.

This is often the most underutilized benefit at a rental sale — many investors don't realize those suspended losses finally get used. Check your prior-year Form 8582 for your accumulated carryforward balance.

Short-term vs. long-term: holding period matters

Holding at least one year and one day is the threshold for long-term capital gains treatment. If you sell sooner, the appreciation portion is taxed as ordinary income at rates up to 37% — the same rate as §1245 recapture, but on top of it. Short-term sales essentially lose the LTCG rate advantage entirely.

§1250 recapture still applies at the 25% cap even on short-term sales — that's a statutory rate ceiling, not a holding-period rule. And NIIT still applies for passive investors regardless of holding period.

Worked example: 8-year rental sale, no cost segregation

Take a married couple, filing jointly, with $180,000 of other taxable income. They sell a residential rental they've held for 8 years.

• Purchase price: $480,000 (land $80,000 + building $400,000)
• Depreciable basis: $400,000 (building only)
• Annual depreciation: $400,000 ÷ 27.5 = $14,545/year
• Total depreciation taken (8 years): $116,364
• Adjusted basis at sale: $480,000 − $116,364 = $363,636
• Sale price: $700,000, selling costs $21,000
• Net proceeds: $679,000
• Total realized gain: $679,000 − $363,636 = $315,364

How the gain splits:

The couple nets $679,000 from the sale but pays $70,924 in federal tax on the gain — plus state taxes. Their remaining mortgage ($190,000) comes off the proceeds too, leaving roughly $418,000 in cash after mortgage payoff and federal taxes. Use the depreciation recapture calculator to model your own numbers.

With cost segregation (same property): If this couple had done a cost seg study at purchase and taken $80,000 in bonus depreciation on 5/7-year components, total depreciation would be $196,364 (not $116,364). Adjusted basis drops to $283,636. The gain rises to $395,364. The §1245 layer adds $80,000 × 37% = $29,600 of ordinary-rate tax on top of everything else — total federal tax roughly $95,000. The cost seg deductions accelerated a $29,600 future tax bill into immediate savings at purchase, creating favorable timing arbitrage — but the recapture must still be planned for.

State capital gains taxes

Federal taxes are only part of the picture. State capital gains taxes are determined by the location of the property, not where you live — so an investor in Texas who owns a rental in California owes California state tax on the gain. States tax real estate gains differently:

• No income tax: Texas, Florida, Nevada, Wyoming, Washington (no personal income tax), Tennessee, South Dakota
• Favorable treatment: Some states follow the federal preferential rate structure; others have lower flat rates
• High-tax states: California (up to 13.3%, no preferential rate for capital gains), New York (up to 10.9% state + city), Minnesota (9.85%), New Jersey (10.75%)

California treats capital gains as ordinary income with no preferential rate. A California investor in the worked example above could owe an additional $38,000+ in state tax — pushing total combined tax to over $108,000 on the same $315,364 gain.

The holding period and depreciation schedule interact

A property held for 4 years has accumulated less depreciation recapture than one held for 15 years — but the appreciation (gain) is typically smaller too. Some investors assume that "selling early" avoids recapture. It partially does on §1250, but:

• If you did a cost seg study, most of the §1245 recapture was front-loaded in year 1 under bonus depreciation — you can't "not sell early" to avoid it
• Short-term gain (under 1 year) is taxed at ordinary rates on the appreciation too, which is worse than LTCG + recapture combined
• The PAL carryforwards that offset gain accumulate over time — a longer hold often means a larger offsetting carryforward too

Five strategies to reduce what you owe

1. 1031 exchange — defer everything

A properly executed 1031 exchange rolls all four layers of tax into the replacement property's basis. You pay nothing at the exchange — §1245 recapture, §1250 recapture, LTCG, and NIIT are all deferred. The downside: strict 45/180-day deadlines, you must trade equal-or-up in value, and the tax bill follows you to the replacement property. Done as a cascade into death, it's the foundation of an estate plan where appreciated real estate passes to heirs with a full step-up in basis — permanently eliminating the tax. See the 1031 exchange calculator and the full 1031 exchange guide.

2. Installment sale — spread LTCG and §1250 over years

Seller financing under IRC § 453 lets you spread the capital gains portion and §1250 recapture across the payment period — potentially keeping you in lower rate brackets each year. Critical trap: §1245 recapture (cost seg depreciation) cannot be spread — it's recognized in full in the year of sale under IRC § 453(i), regardless of when you receive payment. Full analysis at installment sale guide.

3. Harvest PAL carryforwards before you sell

If you have other passive income sources (syndication investments, other rentals producing taxable income), you may be able to accelerate the use of PAL carryforwards before the sale year — reducing the carryforward that releases in the sale year and shifting those deductions to earlier, potentially higher-income years. Works best when you expect lower income in future years. Requires coordination with a tax advisor.

4. Sell in a low-income year

LTCG rates depend on total taxable income that year. If you retire or take a sabbatical, a year of lower income can drop you from the 20% bracket to the 15% bracket — or even to 0% for a portion of the gain. Planning a sale around income reduces all rate-bracket-sensitive layers. The §1250 cap at 25% and the fixed $200K NIIT threshold aren't affected, but LTCG savings can be meaningful.

5. Die (seriously — hold-to-death cascade)

IRC § 1014 resets the basis of inherited property to fair market value at the date of death. All §1245 recapture, §1250 recapture, and LTCG are permanently eliminated — your heirs inherit the property with a fresh basis and no deferred tax. For investors with appreciated, highly depreciated portfolios, 1031-exchange-until-death is the most effective tax strategy available — not as a morbid planning hack, but as the actual intended mechanism of stepped-up basis. A financial advisor can help structure this intentionally. See stepped-up basis guide and estate planning guide.

When an advisor actually changes the outcome

Most of the decisions that affect your tax bill at sale were made years earlier:

• Did you do a cost seg study? (Affects §1245 recapture and the timing of your tax benefit)
• Did you qualify for REPS? (Eliminates NIIT and allows current-year use of depreciation losses)
• Did you accumulate PAL carryforwards, or did you release them through passive income?
• Is a 1031 exchange viable — do you have a replacement property in mind?
• Should you sell this year, or plan a low-income year for the exit?

By the time you're under contract, most of these decisions are locked in. A specialist advisor's value is in the 1–5 years before the sale — when entity structuring, REPS qualification, installment sale structuring, or a planned 1031 cascade can materially change the outcome. The depreciation recapture calculator will show you your current tax exposure; an advisor tells you whether there's still time to change it.

Sources

1. IRC § 1245 — Gain from Dispositions of Certain Depreciable Property. Depreciation recapture on personal property (5/7-year assets including cost segregation components) is recognized as ordinary income in the year of sale. No rate cap applies. Verified 2026.
2. IRC § 1250 — Gain from Dispositions of Certain Depreciable Realty. Straight-line depreciation on real property (27.5/39-year) constitutes "unrecaptured §1250 gain" taxed at a maximum 25% rate per IRC § 1(h)(1)(D). Cross-referenced with IRS Form 4797 Instructions.
3. Kiplinger: IRS Updates Capital Gains Tax Thresholds for 2026. 2026 LTCG thresholds: 0% to $49,450/$98,900 (single/MFJ); 15% to $545,500/$613,700; 20% above. Per IRS Rev. Proc. 2025-32. Cross-referenced with Tax Foundation 2026 Brackets.
4. IRS Topic 559 — Net Investment Income Tax. IRC § 1411 imposes 3.8% surtax on lesser of NII or MAGI excess above $200K single / $250K MFJ. Threshold not indexed for inflation. Cross-referenced with IRS NIIT Q&A.
5. IRC § 469(g) — Passive Activity Loss Release on Full Disposition. When a taxpayer fully disposes of a passive activity in a taxable transaction, all suspended passive activity losses are released and allowed in the year of disposition.
6. IRS Publication 946 — How to Depreciate Property (2025). 27.5-year recovery period for residential rental property; 39-year for commercial real property. Mid-month convention applies to all § 1250 property.

Tax rates and thresholds verified as of May 2026 against IRS Rev. Proc. 2025-32 and IRC § 1411. 2026 LTCG thresholds per Kiplinger/IRS. NIIT threshold ($200K/$250K) is statutory and not inflation-adjusted. Consult a qualified tax advisor for your specific situation.