Rental property course · Lesson 5 of 6
The sale gives back the depreciation, and the tax law taxes it.
There are three ways to get the equity out of a rental: sell, exchange or refinance. Each one gives a different amount of cash and a different tax bill.
The gain
| Sale after 10 years | $ |
|---|---|
| Sale price, year 10 | 403,175 |
| Costs of the sale, 6% | (24,190) |
| Amount realized | 378,984 |
| Cost of the property | 306,000 |
| Less depreciation taken | (88,276) |
| Adjusted basis | 217,724 |
| Gain | 161,261 |
Each dollar of depreciation lowered the basis. So the gain includes the $88,276 of depreciation that Example House took, plus the growth in value less the costs.
The tax on the sale
| Part | $ | Rate | Tax, $ |
|---|---|---|---|
| Depreciation part of the gain | 88,276 | 22% | 19,421 |
| Rest of the gain | 72,984 | 15% | 10,948 |
| Net investment income tax | 3.8% | 1,965 | |
| Total tax on the sale | 32,334 |
The depreciation part of the gain is taxed at your ordinary rate, but at no more than 25%. For this household, it falls in the 22% bracket. The rest of the gain is a long-term capital gain. Taxable income stays below $613,700, so the rate is 15%.
The sale also lifts modified AGI to $301,716. Above $250,000, the 3.8% net investment income tax applies to the lower of the investment income or the excess. That threshold does not grow with inflation.
| Cash at the sale | $ |
|---|---|
| Amount realized | 378,984 |
| Loan repaid | (193,078) |
| Tax | (32,334) |
| Cash to the owner | 153,573 |
A 1031 exchange
A 1031 exchange swaps one investment property for another, and the tax waits. Only real property held for business or investment qualifies. A home that you live in does not.
You have 45 days after the sale to name the possible new properties. You must complete the purchase within 180 days. A qualified intermediary holds the cash between the two. The tax of $32,334 is deferred, not forgiven.
A cash-out refinance
A refinance is a new loan, not a sale, so no tax on a sale is due. Suppose that the owner borrows 75% of the value at 7%: $302,381. After the old loan of $193,078 and costs of $6,048, the owner gets $103,256 of cash.
The cost is the new payment of $24,141 a year. Year 11 cash flow falls from $5,382 to -$796. The cash comes out now, but the house pays less each month.
| Choice | Cash now | Tax | Cash flow after |
|---|---|---|---|
| Sell | $153,573 | $32,334, due now | None |
| 1031 exchange | Stays in the new property | $32,334, deferred | From the new property |
| Cash-out refinance | $103,256 | None, because there is no sale | -$796 in year 11 |
Key points
- At a sale, the depreciation that you took comes back as gain, taxed at up to 25%.
- A 1031 exchange defers the tax. It does not cancel it.
- A refinance gives cash without a sale, but it raises the payment.
Sources
- IRS, Topic 409, Capital Gains and Losses, for the maximum rate of 25% on unrecaptured section 1250 gain.
- Kiplinger, IRS Updates Capital Gains Tax Thresholds for 2026, for the 15% band of $98,900 to $613,700 for married couples with a joint return.
- IRS, Net Investment Income Tax, for the 3.8% rate, the $250,000 threshold and rental income.
- IRS, Questions and Answers on the Net Investment Income Tax, for thresholds that are not indexed and gain from investment real estate.
- IRS, Like-Kind Exchanges, Real Estate Tax Tips, for the rule that only real property held for business or investment qualifies.
- IRS, Fact Sheet 2008-18, Like-Kind Exchanges Under IRC Section 1031, for the 45-day and 180-day deadlines, the qualified intermediary and gain that is deferred, not tax-free.