Capital Gains Tax on Rental Property Explained

Capital gains tax on rental property applies when an investor sells a rental at a price above its adjusted basis. Adjusted basis starts with the original purchase price plus qualifying improvements, then subtracts total depreciation claimed over the holding period. Because depreciation lowers basis every year, a rental that has been held for a long time often produces a larger taxable gain than the simple difference between purchase price and sale price would suggest.

The gain splits into two pieces for federal tax purposes. The portion attributable to depreciation already claimed is taxed as unrecaptured Section 1250 gain, capped at a twenty five percent federal rate. The remaining appreciation above the original basis is taxed at long term capital gains rates, generally zero, fifteen, or twenty percent depending on the investor's taxable income, assuming the property was held for more than one year. Investors with higher income may also owe the three point eight percent net investment income tax on top of these rates. Colorado, CO investors add a state layer on top of the federal calculation, since Colorado taxes capital gain as ordinary income under its flat state income tax rate rather than offering a separate lower capital gains rate.

A 1031 exchange defers all of this, both the capital gains portion and the depreciation recapture portion, as long as the investor sells a rental held for investment or business use and reinvests the full net proceeds into another qualifying real property of equal or greater value. The exchange does not forgive the tax. It rolls the deferred gain and the reduced basis forward into the replacement property, where it stays deferred until the investor sells without exchanging again, or is eliminated entirely if the property passes to heirs and receives a stepped up basis at death.

Denver, CO investors selling long held rental property, particularly in neighborhoods where values have appreciated significantly since purchase, often find the combined federal and state liability large enough that a 1031 exchange changes the entire decision of whether and when to sell. Running the numbers before listing the property, rather than after closing, is what preserves the option to exchange, since the forty five day identification clock starts the day title transfers.

Investors who do not plan to exchange should still calculate the expected liability well before closing so financing, timing, and estimated tax payments can be planned around the actual number rather than an assumption.