When you sell a rental, your gain is the amount realized minus your adjusted basis, and that basis has been reduced by every dollar of depreciation allowed or allowable. Federally, the part of a long-term gain on the building that comes from depreciation is unrecaptured section 1250 gain, taxed at up to 25% under IRC § 1(h); the rest of a long-term gain uses the 0%, 15% and 20% capital gain rates, and the 3.8% net investment income tax may apply. California has no lower capital gain rate and taxes the whole gain as ordinary income.

The short version

  • Gain is the amount realized (money, the fair market value of property received, and liabilities the buyer assumes) minus adjusted basis.
  • Depreciation lowers basis whether or not you claimed it ("allowed or allowable").
  • Depreciation on the building generally becomes unrecaptured § 1250 gain, taxed at up to 25%. Depreciation on appliances, carpet, furniture and similar § 1245 items is ordinary income.
  • Long-term capital gain rate brackets are set by taxable income; the 2025 and 2026 figures are below.
  • The 3.8% net investment income tax uses fixed thresholds that are not indexed for inflation.
  • A fully taxable sale of your entire interest to an unrelated buyer releases suspended passive losses.

How the gain is figured

Pub 544 defines the amount realized as "the total of all the money you receive plus the fair market value ... of all property or services you receive," and it includes liabilities the buyer assumes. Subtract your adjusted basis, which starts with what you paid (including certain settlement costs) and is reduced by depreciation.

The depreciation piece is where many owners are surprised. Pub 527 says that "if you didn't claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted." So skipping depreciation does not avoid tax on it later. See rental property depreciation for how basis and the 27.5-year schedule work.

How each part of the gain is taxed (federal)

Part of the gainFederal treatmentSource
Depreciation on the building (§ 1250 property), held more than 1 year, straight lineUnrecaptured § 1250 gain, taxed at up to 25%IRC § 1(h)(1)(E), (h)(6); Pub 544
Depreciation on § 1245 property (appliances, carpet, furniture, cost segregation components)Ordinary income to the extent of depreciation allowed or allowablePub 544
Remaining long-term gain0%, 15% or 20% capital gain rates, by taxable incomeIRC § 1(h); Rev. Proc. 2024-40; Rev. Proc. 2025-32
Net investment income3.8% NIIT may apply on topIRC § 1411

Unrecaptured section 1250 gain

Pub 544 describes it as "the part of any long-term capital gain on section 1250 property (real property) that is due to depreciation." The 25% figure is a maximum rate, not a flat rate. For 2025, Pub 544 lists the maximum rates for individuals as "0%, 15%, 20%, 25%, and 28%." The amount is figured on the Unrecaptured Section 1250 Gain Worksheet in the Schedule D instructions.

Ordinary-income recapture under § 1250 reaches only "additional depreciation," meaning depreciation faster than straight line, or property held 1 year or less. Residential rental buildings must use straight line, so for a building held more than a year, depreciation gain is generally unrecaptured § 1250 gain rather than ordinary income. Pub 544 also conditions this, for qualified property, on a timely election not to claim any special depreciation allowance.

Long-term capital gain brackets

These are taxable income thresholds, not income thresholds. Above the 15% amount, the 20% rate applies.

Filing status2025: 0% up to2025: 15% up to2026: 0% up to2026: 15% up to
Married filing jointly / surviving spouse$96,700$600,050$98,900$613,700
Married filing separately$48,350$300,000$49,450$306,850
Head of household$64,750$566,700$66,200$579,600
Single$48,350$533,400$49,450$545,500

The 3.8% net investment income tax

The NIIT is 3.8% of "the lesser of their net investment income, or the amount by which their modified adjusted gross income exceeds the statutory threshold amount." The thresholds are $250,000 for married filing jointly, $125,000 for married filing separately, $200,000 for single or head of household, and $250,000 for a qualifying widow(er) with a child. The IRS notes these "are not indexed for inflation."

Rental income and gain on selling a rental are generally net investment income. An exception can apply when the rental is part of a non-passive trade or business, such as for some real estate professionals; ask a tax professional whether it fits you. Gain excluded under § 121 is not subject to NIIT. The tax is reported on Form 8960.

Suspended passive losses

Rental losses you could not deduct in earlier years carry forward. Under § 469(g), they are released when you dispose of your "entire interest" in a transaction in which all gain or loss is recognized, and the buyer must not be related to you. The Form 8582 instructions say losses not allowed are carried forward until allowed, including "when you sell or exchange your entire interest in the activity in a fully taxable transaction to an unrelated party."

A few limits apply:

  • In an installment sale of your entire interest, losses are released in proportion to the gain recognized each year (Pub 925).
  • The release covers "passive activity losses (but not credits)."
  • Suspended losses generally are freed only by a fully taxable disposition, so a § 1031 exchange may not release them. See 1031 exchange basics and passive loss rules.

California differences

  • No capital gain rate. The FTB says: "California does not have a lower rate for capital gains. All capital gains are taxed as ordinary income." There is no separate 25% rate for the depreciation part; California taxes the whole gain at ordinary rates.
  • Top rate. For 2025, California's top regular rate is 12.3%, plus 1% on taxable income over $1 million (the Behavioral Health Services Tax).
  • Different basis. California never allowed bonus depreciation and capped § 179 at $25,000 for 2025, so many owners have a different depreciation total and adjusted basis for California. The California gain can differ from the federal gain. Business property adjustments go on Schedule D-1, and depreciation differences on FTB 3885A. Keep both depreciation schedules.
  • Passive losses. For California, all rental activities are passive, and the federal real estate professional rule does not apply (R&TC 17561(a)), so the losses released on sale can differ. They are figured on FTB 3801.
  • Withholding at escrow. California generally requires withholding of 3 1/3% of the sales price, or an elected alternative amount, unless an exemption applies on Form 593. See California withholding when you sell a rental.
  • Out-of-state sellers. The gain on selling California real property is California-source income, so a nonresident reports it on Form 540NR.

What to do next

  1. Gather your purchase closing statement, records of every improvement, and each year's depreciation schedule, federal and California.
  2. Find any suspended passive loss carryovers on prior Forms 8582 and FTB 3801.
  3. Ask your tax professional to estimate the federal and California gain before you list, including NIIT and any § 1245 recapture.
  4. Decide early whether a 1031 exchange or the home sale exclusion could apply, because both have timing rules.
  5. Plan for Form 593 with your escrow officer before closing.
  6. If you are weighing selling against keeping the rental, compare the numbers in the rental cash flow calculator. Selling with a tenant in place has its own rules; see selling a rental with tenants in place.

McKee Properties manages rentals from its Coronado office; contact us with questions about your property.

Frequently asked questions

Is depreciation recapture on a rental always taxed at 25%?

No. For the building, the depreciation part of a long-term gain is unrecaptured § 1250 gain taxed at up to 25%; 25% is a maximum rate, not a flat rate. Depreciation on § 1245 items such as appliances, carpet and furniture is taxed as ordinary income. California has no separate rate and taxes the whole gain as ordinary income.

What if I never claimed depreciation on my rental?

Your basis is still reduced by the depreciation you could have claimed. Pub 527 says you must reduce basis by the full amount you were entitled to deduct, so the gain on sale is figured as if you had claimed it. Pub 946 explains how unclaimed depreciation can be corrected, which is work for a tax professional.

Does the 3.8% net investment income tax apply when I sell a rental?

It can. Gain on selling a rental is generally net investment income, and the tax applies to the lesser of that income or your modified adjusted gross income above $250,000 (married filing jointly), $125,000 (married filing separately) or $200,000 (single or head of household). An exception can apply for some real estate professionals, so ask your tax professional.

What happens to my suspended passive losses when I sell?

A fully taxable sale of your entire interest to an unrelated buyer releases them, so they can be deducted that year. Credits are not freed this way. An installment sale releases losses in proportion to gain recognized each year, and a 1031 exchange may not release them because it is not fully taxable.

Does California tax the gain if I live in another state?

Yes. The gain on selling California real property is California-source income, and nonresidents report it on Form 540NR. California generally also requires withholding at escrow unless an exemption applies on Form 593, and the amount withheld is claimed as a credit on your return.

This is general information, not tax or legal advice. Tax rules change and depend on your facts; talk to a CPA or enrolled agent before acting.

Sources

Verified October 19, 2026.

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