Form 4797: How to Report the Sale of a Rental Property

When selling a rental property, taxpayers report the transaction on Form 4797, Sales of Business Property. This IRS form is used to calculate the gain or loss from the disposal of assets used in a trade or business, which includes properties held to generate rental income. For tax purposes, a rental property is considered a business asset, and its sale is subject to distinct rules that differ from the sale of a personal residence. Correctly using Form 4797 involves determining the property’s basis, accounting for depreciation, and classifying the gain or loss to calculate the final tax liability.

When to Use Form 4797 for a Rental Property Sale

Form 4797 is required when you sell real property that has been used for business purposes and held for more than one year. Rental properties fit this description as they are income-producing assets classified under Internal Revenue Code Section 1231. This classification provides a specific tax treatment where a net gain is treated as a long-term capital gain, while a net loss can be deducted as an ordinary loss.

This treatment differs from the sale of a primary residence. When you sell your main home, you may be eligible to exclude up to $250,000 of the gain from your income ($500,000 if married filing jointly) under Section 121. This exclusion is not available for a property that has been used exclusively for rental purposes. If a property was used as both a primary residence and a rental, reporting can be more complex, potentially requiring an allocation of the gain.

Information Required to Complete Form 4797

Before filling out Form 4797, a taxpayer must gather several key pieces of financial information. Proper record-keeping throughout the period of property ownership simplifies this process. You will need the following:

• Original cost basis, which is the starting point and includes the purchase price plus certain closing costs from the acquisition, such as legal fees, surveys, and transfer taxes.
• A list of all capital improvements, which are expenses that add to the property’s value or prolong its life, such as replacing a roof, as opposed to routine repairs.
• Sale details from the transaction, including the gross sale price and the date of the sale, which are often found on the closing statement or Form 1099-S.
• A record of all selling expenses, which are deducted from the sale price and include real estate commissions, advertising costs, and legal fees for the sale.
• The total depreciation history, which is the amount of depreciation claimed or that could have been claimed. The IRS requires accounting for all allowable depreciation, even if it was not taken.

Calculating Gain, Loss, and Depreciation Recapture

With the necessary information gathered, you can determine the tax consequences of the sale. This involves calculating the property’s adjusted basis, the total gain or loss, and the portion of the gain subject to depreciation recapture.

First, you must calculate the adjusted basis of the property. The formula is the original cost basis, plus the total cost of all capital improvements, minus the total depreciation allowed or allowable. For instance, if a property was purchased for $250,000, had $30,000 in capital improvements, and you claimed $50,000 in depreciation, the adjusted basis would be $230,000 ($250,000 + $30,000 – $50,000).

Next, you calculate the total gain or loss. This is found by taking the gross sale price and subtracting both the selling expenses and the adjusted basis. If the property with the $230,000 adjusted basis was sold for $350,000, with $20,000 in selling expenses, the total gain would be $100,000 ($350,000 – $20,000 – $230,000).

A significant component of the gain is depreciation recapture. This is the portion of the gain that results from the depreciation deductions you took. The IRS requires you to “recapture” this gain, which for real estate is known as unrecaptured Section 1250 gain and is taxed at a maximum rate of 25%. The amount of depreciation to be recaptured is the lesser of the total depreciation taken or the total gain on the sale.

In our example, the total gain is $100,000 and total depreciation was $50,000. Therefore, $50,000 of the gain is considered unrecaptured Section 1250 gain. The remaining $50,000 of the gain is treated as a Section 1231 gain, which is taxed at the lower long-term capital gains rates of 0%, 15%, or 20%, depending on your income.

Completing the Sections of Form 4797

Once the calculations for adjusted basis, total gain, and depreciation recapture are complete, you can fill out Form 4797. The form is structured to guide you through reporting different types of property. For a rental property sale, the process often begins in Part III.

Part III

Part III is titled “Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255.” For the sale of a depreciable rental building held over a year, this is the starting point. Here, you will enter a description of the property, the dates it was acquired and sold, the gross sales price, the basis plus improvements, and the total depreciation. The form then guides you to calculate the total gain and determine the amount of depreciation recapture.

Part I

The results from Part III flow to other parts of the form. The portion of the gain not subject to depreciation recapture is carried to Part I, “Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions.” This is where you report Section 1231 gains and losses. If you also sold the land the rental property was on, that transaction is reported directly in Part I, as land is not depreciable.

Part II

Part II of the form is for reporting ordinary gains and losses. This section is used for property held for one year or less or for other transactions that do not qualify for Section 1231 treatment. For a straightforward sale of a long-term rental property, this part may not be used.

Reporting the Outcome on Your Tax Return

Completing Form 4797 is not the final step; the results must be integrated into your overall tax return. The figures calculated on Form 4797 flow to other schedules and forms, ultimately affecting your total tax liability. The two primary figures from the sale are reported in different places.

The depreciation recapture amount, identified as unrecaptured Section 1250 gain, is used to calculate your tax. It flows through Schedule D but is subject to its own tax rate. A specific worksheet in the tax instructions, the “Unrecaptured Section 1250 Gain Worksheet,” ensures this gain is taxed at the correct maximum 25% rate.

The remaining Section 1231 gain from Part I of Form 4797 is carried over to Schedule D, Capital Gains and Losses. On Schedule D, this gain is combined with any other capital gains and losses you may have from other transactions. The net result on Schedule D then transfers to your Form 1040, your main tax return.