How to Calculate Capital Gains on Income Property

When an income-producing property sells for more than its adjusted cost basis, the profit is a capital gain subject to taxation. The tax regulations for investment properties are distinct from those for a primary residence, making it important to understand the rules for calculating the financial outcome. The process requires a detailed calculation of the property’s adjusted basis, which accounts for improvements and depreciation over the holding period.

Calculating Your Capital Gain

The capital gain is calculated with a straightforward formula: the property’s final sale price minus its adjusted basis. The accuracy of this calculation is important, as an error in determining either the sale price or the adjusted basis can lead to an incorrect gain and potential tax issues.

The sale price is the gross amount the property sold for, reduced by selling expenses. Deductible expenses include real estate agent commissions, attorney fees, closing costs, and advertising costs. For example, if a property sells for $500,000 with $35,000 in commissions and closing costs, the amount used for the calculation is $465,000.

The adjusted basis represents the total investment in the property for tax purposes. It starts with the original cost basis, which is the purchase price plus acquisition costs like title insurance and transfer fees. This basis is then increased by the cost of capital improvements, which are expenses that add value, prolong the property’s life, or adapt it to new uses, such as a new roof or room addition.

It is important to distinguish between a capital improvement and a repair. Repairs, like painting or fixing a leak, are routine maintenance costs deducted annually as rental expenses and do not increase the property’s basis. A final step in calculating the adjusted basis is subtracting all accumulated depreciation, which is an annual deduction for the wear and tear on the building.

The IRS mandates that you reduce your basis by the amount of depreciation you were allowed to take, regardless of whether you claimed the deduction. This “allowed or allowable” rule means the basis is reduced by the amount of depreciation that could have been lawfully claimed, preventing owners from avoiding depreciation to report a smaller capital gain.

For example, an investor buys a rental property for $300,000 and spends $50,000 on capital improvements. Over the years, they were entitled to $75,000 in depreciation. The adjusted basis is $275,000 ($300,000 + $50,000 – $75,000). If they sell the property for a net price of $465,000, their total capital gain is $190,000.

Understanding the Tax Liability

After calculating the total capital gain, the next step is determining the tax owed. The gain from an income property sale is often split into two parts, each with a different tax treatment.

The portion of your capital gain from depreciation deductions is subject to depreciation recapture. This amount is not eligible for lower long-term capital gains rates and is taxed at a maximum rate of 25%. In the previous example, of the $190,000 total gain, the $75,000 from depreciation would be subject to this 25% tax.

The rest of the gain is a standard capital gain, and its tax rate depends on the holding period. If held for more than one year, it is a long-term capital gain taxed at 0%, 15%, or 20%, depending on the seller’s taxable income. If held for one year or less, it is a short-term capital gain taxed at the seller’s ordinary income tax rates.

Continuing the example, the remaining gain is $115,000 ($190,000 – $75,000). Assuming a long holding period, this $115,000 is a long-term capital gain. It would be taxed at 0%, 15%, or 20%, depending on the seller’s income.

Higher-income taxpayers may face the 3.8% Net Investment Income Tax (NIIT). This tax applies to the lesser of net investment income or the amount by which modified adjusted gross income exceeds certain thresholds ($200,000 for single filers, $250,000 for married filing jointly). A capital gain from a rental property is net investment income. Most states also impose their own income tax on capital gains, which adds to the total liability.

Strategies for Deferring Capital Gains Tax

Investors can use strategies to defer, but not eliminate, capital gains tax, allowing the investment to grow tax-free. The most common strategy is a 1031 exchange, which allows for the deferral of both capital gains and depreciation recapture taxes.

A 1031, or like-kind, exchange allows an investor to sell an investment property and reinvest the proceeds into a new one. For real estate, “like-kind” is broad, allowing exchanges between different property types like a vacant lot for an apartment building. Both the sold and acquired properties must be held for investment or business use.

The process is governed by strict timelines. From the closing date of the original sale, the investor has 45 days to identify potential replacement properties. The purchase of an identified property must be completed within 180 days of the original sale date, and these deadlines run concurrently.

A valid 1031 exchange requires using a Qualified Intermediary (QI). To prevent the investor from having receipt of the sale proceeds, the funds must be held by the independent QI. The QI receives the funds from the first sale and disburses them for the new property purchase, ensuring the investor never has control of the money.

An alternative strategy is the installment sale, which is useful for sellers who want to spread out the tax impact instead of reinvesting. The seller receives payments from the buyer over several years and reports a portion of the capital gain each year as payments are received. This can help the seller remain in a lower tax bracket.

Reporting the Sale on Your Tax Return

The sale of an income property is reported on Form 4797, Sales of Business Property. This form is used to calculate and report the depreciation recapture portion of the gain. It separates the gain into its ordinary income component (from recapture) and its capital gain component.

The capital gain portion calculated on Form 4797 flows to Schedule D, Capital Gains and Losses. On Schedule D, this gain is combined with other capital transactions to determine the net capital gain or loss for the year. This final figure is then carried over to the main Form 1040.

If a 1031 exchange was performed, the taxpayer must file Form 8824, Like-Kind Exchanges. This form demonstrates that the transaction met all requirements of a valid exchange. It details the properties, timelines, and the amount of gain being deferred, which is used to adjust the basis of the new property.