Calculate capital gains tax on sale of rental property

This short article is a breakdown of what goes into calculating capital gains for the sale of a rental property. We’ll use a fictitious example so you can see how the numbers work out.

We’re going to use a sale of $400,000 on a rental property that was purchased for $340,000 four years ago. There are a few steps to calculating your rental property gains. Let’s work through them.

1. Calculate the purchase price or basis of your rental property.

The original basis is your purchase price or $340,000 in this case. In the scenario that you have carried over basis through multiple contiguous 1031 exchanges, your starting basis may be lower. Consult a tax professional for determining your starting basis.

1. Add any expenditures you've made in order to improve the quality of the property or other items that increase the basis.

Improvements — or capital improvements — increase the tax basis of the property and are added to the purchase price. There have been $25,000 in renovations made, and they must be “a material part of” the property. These are physical improvements, and they must add “real” value. Meaning, an appraiser would add value to the property based on the renovations. Other items that increase basis include assessments for local improvements, impact fees, legal fees, and zoning costs.

In this scenario our adjusted basis would look like this:

$340,000 + $25,000 = $365,000

1. Subtract any depreciation you've taken on the property and any other items that decrease basis.

Items such as depreciation, canceled debt, insurance proceeds for casualty or theft, proceeds from easements, and rebates decrease the property’s tax basis and are subtracted from the cost basis. For our example, the property had $25,000 in insurance reimbursements and the depreciation taken was $10,000 per year for four years. The adjusted basis now looks like:

$365,000 - $25,000 - $40,000 = $300,000.

1. Subtract the adjusted basis from the sales price to determine what gains will be taxed under the current capital gains tax rate.

Now we can finally calculate our gains. Your total gain is simply your sale price less your adjusted tax basis.

Capital gain in this scenario: $400,000 - $300,000 = $100,000. 

1. Depreciation is taxed at 25%, and capital gains are taxed based on your tax bracket. 

Long-term gains typically end up being taxed at either 15% or 20%, depending on your income for the year. Depreciation recapture, however, is taxed at a flat rate of 25% on any part of the gain that is attributable to depreciation. In this scenario, that would be $40,000 out of the $100,000 total gain. 

With $40,000 in depreciation, our taxes will be $40,000 x 25% = $10,000 of depreciation recapture tax.

The remaining portion of our gain is taxed at your long-term capital gains tax rate, assuming we’ve held the property for more than a year. If we are in a 20% long-term capital gains tax bracket, our total taxes on this portion of the gain are: $60,000 x 20% tax rate = $12,000.

At this point, our capital gains tax liability would be $22,000 ($10,000 depreciation recapture + $12,000 on long-term gain).

1. Add 3.8% Affordable Care Act surtax in most cases.

The Affordable Care Act surtax or NIIT (net investment income tax) is another 3.8%. This tax applies to those filing single, with an income over $200,000 or married filing jointly with an income over $250,000. We don’t have an example of this calculation as it depends on your unique tax and income situation.

1. Add state taxes based on where the investment property is located.

State taxes must also be included on your capital gains. If your property is in New York state, where the rate is 8.82%, taxes on this $100,000 gain will be $8,820.

Calculating capital gains on the sale of a rental property is an involved process. To avoid missing anything in the calculations and getting penalized for it, it’s best to work with your tax advisor.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.

Realized does not offer legal or tax advice.

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