Reducing Capital Gains Tax on a Rental Property

Receiving regular rental income can help you grow wealth and diversify your income streams, but you will owe federal and, where applicable, state income taxes on that income. Capital gains tax can also apply ere’swhen you sell a rental property. To avoid these taxes taking too big of a chunk from your earnings, there are strategies you can employ, from leveraging tax exemptions and deductions to strategically timing your sale, that  can make a substantial difference in your net earnings.

Do you have questions about planning your real estate investments? Consider speaking with a financial advisor.

How Rental Property Is Taxed

There are two dimensions to the tax picture when talking about rental properties. First, there’s the tax you pay on rental income paid to you. Second, there are the taxes you might pay if you were to sell a rental property for a profit.

In terms of taxes on rental income, that income is taxed as ordinary income but is not generally subject to self-employment taxes, distinguishing it from wages or side-hustle earnings. In other words, rental income is taxed as ordinary income at whatever your regular tax bracket may be for the year. The good news is that you can reduce what you owe in income taxes on rental income by claiming deductions for depreciation and rental expenses, such as maintenance, upkeep and repairs.

Meanwhile, when you sell a rental property, you may owe capital gains tax on the sale. Capital gains tax generally applies when you sell an investment or asset for more than what you paid for it. The short-term capital gains tax rate is whatever your normal income tax rate is and it applies to investments you hold for one year or less. So, for 2026, the maximum you could pay for short-term capital gains on rental property is 37%.

The table below breaks down the 2026 short-term capital gains tax rates by filing status:

Long-term capital gains tax rates, on the other hand, are set at 0%, 15% and 20%, based on your income. These rates apply to properties held for more than one year. If you own rental property as an investment year over year, you may be more likely to deal with the long-term capital gains tax rate.

For reference, this table breaks down the 2026 long-term capital gains tax rates by filing status:

Understanding Adjusted Cost Basis and Depreciation Recapture

When calculating capital gains on a rental property, your adjusted cost basis plays a key role in determining how much of your profit is taxable. The cost basis is generally what you paid for the property, plus certain expenses (like closing costs and major improvements), minus depreciation allowed or allowable over the years.

Depreciation allows property owners to deduct a portion of the building’s value each year to account for wear and tear. While this rental property deduction can lower your taxable rental income annually, it also reduces your property’s cost basis. When you sell the property, the IRS “recaptures” that depreciation by taxing it at a special rate of up to 25%, separate from your standard capital gains rate.

For example, suppose you purchased a rental property for $400,000, allocating $300,000 to the building and $100,000 to the land. Over 10 years, you claimed $109,000 in total depreciation. You later sell the property for $550,000 and incur $25,000 in selling expenses.

Your adjusted cost basis would be:

• Purchase price: $400,000
• Minus depreciation: –$109,000
• Adjusted cost basis: $291,000

Your amount realized after selling expenses would be:

• Sale price: $550,000
• Minus selling expenses: –$25,000
• Amount realized: $525,000

Based on these figures, the total gain on the sale is $525,000 – $291,000 = $234,000.

Of that, $109,000 may be treated as unrecaptured Section 1250 gain, subject to a maximum 25% federal rate, while the remaining $125,000 may be taxed at long-term capital gains rates of 0%, 15% or 20%, depending on your income.

This means your actual tax liability can be higher than you expect if you’ve owned the property for many years and claimed significant depreciation.

To help minimize depreciation recapture and other taxes, it’s often worth consulting a financial advisor or tax professional before selling an investment property.

How Depreciation Can Increase the Gain on a Rental Sale

Depreciation can affect a rental-property sale even when an owner did not claim every deduction that was available. Federal tax rules generally require the property’s basis to be reduced by depreciation that was allowed or allowable. As a result, skipping a depreciation deduction during the rental years does not necessarily prevent that depreciation from increasing taxable gain when the property is sold.

Suppose a landlord buys a property for $360,000 and allocates $275,000 of the purchase price to the depreciable building. Assume $50,000 of depreciation was allowable before the property is sold, but the landlord claimed only $40,000. For purposes of calculating adjusted basis, the basis generally must still reflect the full $50,000 that was allowable under these assumptions.

• $360,000 original basis – $50,000 allowable depreciation = $310,000 adjusted basis

If the property is then sold for a $430,000 amount realized, the simplified gain calculation would be:

• $430,000 amount realized – $310,000 adjusted basis = $120,000 gain

The tax treatment of that $120,000 is not determined by applying one capital gains rate to the entire amount. Gain attributable to depreciation can fall within the rules for unrecaptured Section 1250 gain, which is subject to a maximum 25% federal rate, while the remaining qualifying long-term gain may be taxed under the 0%, 15% or 20% capital gains rate structure. Other rules, including Section 1231 treatment, can also affect the final calculation.

Keeping depreciation schedules, improvement records and purchase and sale documents can make it easier to establish adjusted basis and separate the different components of gain before deciding whether a tax-deferral strategy makes sense.

Reducing Capital Gains on a Rental Property

If you’re interested in minimizing capital gains tax on rental property or deferring it, there are three avenues open to you:

Take Advantage of Tax-Loss Harvesting

Tax-loss harvesting is a strategy that allows you to balance out capital gains with capital losses in order to minimize tax liability. So, if your rental property appreciated significantly in value since you purchased it, but your stock portfolio tanked, you could sell those stocks at a loss to offset your capital gains on the rental property.

Capital losses can offset capital gains, but the interaction between investment capital losses and gain from a rental-property sale depends on how the real estate gain is characterized under the tax rules. As a result, investment losses do not necessarily offset every taxable component of a rental-property sale dollar for dollar.

If your entire portfolio did well over the past year, then you may need to consider other ways to cut your taxes than loss harvesting. It may not yield enough of a benefit to offset all of your capital gains from selling a rental property.

Use a 1031 Exchange

Section 1031 of the Internal Revenue Code allows you to defer paying capital gains tax on rental properties if you exchange qualifying real property held for investment or business use for qualifying like-kind real property, known as a 1031 exchange. You don’t get to avoid paying taxes on capital gains altogether; instead, you’re deferring it until you sell the replacement property.

There are a few rules to know about Section 1031 exchanges. First, both the property you sell and the replacement property must be qualifying like-kind real property held for business or investment use. The good news is that the IRS allows for some flexibility in how like-kind is defined. So, for example, if you own a duplex and you decide to sell it and use the proceeds to purchase a single-family rental home, that could still meet the criteria for a 1031 exchange.

You also need to be aware of the timing and procedural requirements when executing a 1031 exchange. If you want to use this strategy to defer capital gains tax on a rental property, you must identify a potential replacement property within 45 days and complete the closing on the new property by the earlier of 180 days after transferring the relinquished property or the due date, including extensions, of your tax return for the year of the transfer.

In a typical deferred exchange, a qualified intermediary holds the proceeds so you do not take actual or constructive receipt of them. Because the rules are extremely strict, it is strongly recommended that you work with an experienced tax professional or 1031 exchange specialist to review the transaction before the sale.

Again, a 1031 exchange doesn’t let you off the hook for paying capital gains tax on rental property. But it could buy you time for paying those taxes owed if you’re interested in swapping out your rental property for a new one.

Estimate your overall income tax liability with our calculator to see how your earnings may affect what you owe.

Convert a Rental Property to a Primary Residence 

One perk of being a homeowner is that the IRS offers a significant tax break if you sell at a profit. Single filers can exclude up to $250,000 in gains from the sale of a primary home from taxation. That amount doubles to $500,000 for married couples who file a joint return and satisfy the requirements for the larger exclusion.

If you like your rental property enough to live in it, you could convert it to a primary residence to reduce your capital gains tax liability. However, you would still be required to pay tax on gain attributable to depreciation allowed or allowable for rental use after May 6, 1997. There are some rules, however, that the IRS enforces. Generally, you must own and use the property as your main home for at least two years during the five-year period ending on the sale date to meet the Section 121 ownership and residence tests. If you acquired the property in a 1031 exchange, you generally also must own it for at least five years before a sale can qualify for the home-sale exclusion. Periods of nonqualified use can cause another portion of the gain to remain taxable.

This might be something to consider if you’re no longer interested in owning a rental property for income or you’d like to move from your current home into a rental.

Net Investment Income Tax on Rental Property Sales

There’s one more tax layer that rental property investors need to know about, and it’s one that often gets overlooked. The 3.8% net investment income tax (NIIT) can apply on top of your capital gains tax and tax on unrecaptured Section 1250 gain when you sell a rental property. For a profitable sale, this surtax alone can add thousands of dollars to your total bill.

The NIIT kicks in when your modified adjusted gross income exceeds $200,000 if you’re a single filer or $250,000 if you’re married filing jointly. Unlike most tax thresholds, these amounts are not adjusted for inflation, which means more people cross them every year as incomes rise. Once you’re above the threshold, the 3.8% tax applies to whichever is smaller: your total net investment income or the amount by which your MAGI exceeds the threshold.

Rental income generally can count as net investment income when it comes from a passive activity, although exceptions can apply. So if you’re collecting rent and your modified adjusted gross income (MAGI) is above the threshold, you may owe the 3.8% surtax on that rental income on top of your ordinary income tax rate. The calculation depends on the NIIT rules and the taxpayer’s overall net investment income rather than simply adding 3.8 percentage points to the tax rate on every dollar of rent.

The NIIT also applies when you sell a rental property at a gain. A gain from property held in a passive rental activity can be included in net investment income, although the tax applies only to the lesser of net investment income or the excess of MAGI over the applicable threshold. Using the example from earlier in this article, where the total gain on the sale was $234,000, the maximum NIIT attributable to that gain alone would be $8,892 if the full $234,000 were included in net investment income and the taxpayer exceeded the MAGI threshold by at least that amount: $234,000 × 3.8% = $8,892.

Rental property investors are especially likely to hit the NIIT threshold because rental income itself can increase MAGI. A landlord earning $60,000 a year in rental income on top of a $180,000 salary could have MAGI above the $200,000 single-filer threshold, depending on deductions and other adjustments. Add a sale with a six-figure gain and the NIIT exposure can increase. For investors who own multiple properties, the combination of ongoing rental income and sale proceeds in the same year can create a significant surtax bill.

The good news is that the tax reduction strategies discussed earlier in this article can also help with the NIIT. Gain properly deferred in a qualifying 1031 exchange generally is not included in net investment income until it is recognized for federal income tax purposes. Capital losses can also affect the net investment income calculation, subject to the applicable rules and limitations. A qualifying Section 121 home-sale exclusion can keep excluded gain out of net investment income, although gain attributable to depreciation generally cannot be excluded under Section 121.

Bottom Line

Capital gains tax on rental properties can quickly add up if you’re able to sell a property you own for a large profit. Keeping an eye on conditions in the housing market and reviewing your overall financial situation can help you determine whether it’s the right time to sell to minimize taxes. For example, if your regular income is down for the year, then selling a rental property at a capital gain may not carry as much weight if you’re in a lower tax bracket. Talking to a financial advisor can help you find ways to manage capital gains tax.

Tips on Taxes

• Tax planning is a key part of financial planning, which is something for which a professional can provide excellent guidance. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area. You can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Tax-loss harvesting isn’t limited to rental properties. You can also use stock losses to offset stock gains, for example. One thing to keep in mind, however, is the IRS wash-sale rule. This rule specifies that you can’t sell a losing stock and then replace it with a substantially similar one in the 30 days before or after the sale.

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