Real Estate · 7 min read
The Three Exits From a Rental Property
A rental property has three exits, and each treats the tax differently. Sell it and the gain is taxed in the year of sale; the part that reflects the depreciation deducted is taxed back at up to 25 percent, the rest at long-term capital gains rates, and the 3.8 percent surtax on investment income can apply on top. Exchange it for another property and the tax is deferred, not erased: the gain and the depreciation history move into the next building. Hold it until death and the value resets for the heirs, and the depreciation is not taxed back. The right exit depends on the household, not the building.
A rental property has three exits, and the tax bill is different at each one. Sell it and the gain is taxed in the year of sale, including the depreciation deducted along the way. Exchange it for another property and the tax is deferred, not erased. Hold it until death and much of that tax never comes due. Households that built their wealth in rentals usually know the first exit well and the other two only by rumor.
What a sale triggers
A residential rental building is depreciated in a straight line over 27½ years, a commercial building over 39 years, and land is never depreciated (26 U.S.C. §168(b)(3), (c)). Each year’s deduction lowers what the tax code treats as your cost in the building, called the adjusted basis (26 U.S.C. §1016(a)(2)). When the building is sold, the gain is measured against that lowered figure, not the price paid.
That is why a sale taxes the depreciation back. The slice of the gain that reflects depreciation is called unrecaptured section 1250 gain, taxed at the seller’s regular income-tax rate up to a ceiling of 25 percent (26 U.S.C. §1(h)(1)(E), (h)(6)(A); IRS Tax Topic 409). The rest is long-term capital gain, taxed at 0, 15, or 20 percent depending on the household’s taxable income for the year (IRS Tax Topic 409). The 3.8 percent net investment income tax can reach rents and the gain once modified adjusted gross income exceeds $250,000 on a joint return or $200,000 for a single filer (26 U.S.C. §1411(a), (b), (c)(1)(A)).
The arithmetic on one building
Take a residential building bought for $400,000, not counting the land, with $150,000 of depreciation taken over roughly ten years, and sold for $650,000.
| Step | Amount |
|---|---|
| Building purchased (land excluded) | $400,000 |
| Depreciation deducted over the years | –$150,000 |
| Adjusted basis at sale | $250,000 |
| Sale price | $650,000 |
| Total gain | $400,000 |
| Of which, depreciation taxed back (unrecaptured section 1250 gain) | $150,000 at up to 25% |
| Of which, long-term capital gain | $250,000 at 0%, 15%, or 20% |
| 3.8% surtax on the full gain, if the income thresholds are crossed | up to $15,200 |
| Illustrative federal tax: 25% ceiling and the 15% band, no surtax | about $75,000 |
| Illustrative federal tax: 25% ceiling, the 20% band, and the surtax | about $102,700 |
Illustrative. Not a recommendation. The actual bill depends on the household’s other income in the year and on state tax. The shape is the point: $150,000 of the $400,000 gain is deductions coming home.
Exit one: sell and pay
The plain sale is the right exit more often than the tax numbers suggest. A household that is finished with tenants, repairs, and vacancies is buying its time back. A household that needs the capital for a home, a business, or an income portfolio is converting an asset it cannot spend into one it can. The tax is a price, not a verdict.
The planning question is the year. Both the capital-gain rate and the surtax turn on that year’s income (IRS Tax Topic 409; 26 U.S.C. §1411(b)). Closing in the year after wages stop, or in a year without a large Roth conversion, can move the same gain into a lower band. What a household can decide here is whether the after-tax proceeds do more for it than the building does, and which year gives the sale its best footing.
Exit two: exchange
A like-kind exchange lets an owner trade one investment property for another without recognizing the gain at the time of the trade (26 U.S.C. §1031(a)(1)). Since 2018 the rule covers only real property held for business or investment, not property held primarily for sale (IRS Instructions for Form 8824). An intermediary holds the proceeds between the two closings, so the money never rests in the seller’s own account.
The calendar is strict. The replacement must be identified in writing within 45 days of the sale and received by the earlier of 180 days or the due date of that year’s return, extensions included (26 U.S.C. §1031(a)(3); Form 8824 instructions). Cash taken out, non-real-estate property received, and any net reduction in debt are called boot, and gain is taxed up to that amount (26 U.S.C. §1031(b)). Trade a $650,000 building for a $550,000 one and pocket the difference, and $100,000 of the gain is taxed that year.
The basis of the old property carries into the new one, adjusted for boot and any gain recognized (26 U.S.C. §1031(d)). In the example, the $250,000 adjusted basis, the $150,000 depreciation history, and the $400,000 of gain all travel into the replacement (26 U.S.C. §1250(d)(4)). They come due when it is sold, unless it is exchanged again or held to the third exit. What a household can decide here is whether it wants another building at all, and whether it can find the right one inside a 45-day window.
Exit three: hold to the step-up
When an owner dies holding the property, the heirs’ basis becomes its fair market value at the date of death (26 U.S.C. §1014(a)(1)). The recapture rules do not apply to a transfer at death (26 U.S.C. §1250(d)(2); §1245(b)(2)). If the $650,000 building passes at death instead of being sold, the heirs hold it with a $650,000 basis. The $150,000 of depreciation is not taxed back, and any gain deferred through earlier exchanges disappears with it.
This exit works only if the property actually passes at death. Deeding it to the children during life carries the old basis, and the whole $400,000 of gain, to them (26 U.S.C. §1015(a)). For 2026, estates below $15,000,000 owe no federal estate tax, so for most households in this range the reset carries no federal estate-tax cost (IRS, tax year 2026 inflation adjustments). How the property is titled between spouses decides how much resets at the first death. The will or trust decides who receives it, and whether they are ready to be landlords. What a household can decide here is whether it is willing to hold and manage the building for as long as this exit requires.
The questions before choosing
The three exits are not chosen on the tax rate alone. Four questions usually settle which ones are open.
- Did you ever live in it? A home used as the principal residence for two of the five years before the sale can exclude $250,000 of gain, or $500,000 on a joint return (26 U.S.C. §121(a), (b)(1), (b)(2)(A)). The exclusion shrinks for periods after 2008 when the home was not the residence, though rental years after the family moved out, inside that five-year window, do not count against it (26 U.S.C. §121(b)(5)). The depreciation portion is never excluded (26 U.S.C. §121(d)(6)). A former home turned rental may still have this door partly open.
- Was a cost-segregation study done? A study that carved out fixtures and equipment for faster deductions changes the recapture. Those items are section 1245 property, and their depreciation comes back as ordinary income with no 25 percent ceiling, at rates up to 37 percent in 2026 (26 U.S.C. §1245(a)(1), (a)(3); IRS, tax year 2026 inflation adjustments).
- Which state? State income tax on the gain, where it applies, sits on top of every federal figure above, and states differ in how they treat an exchange and a step-up.
- Who is the next buyer? Each exit has one. A sale needs a market buyer, an exchange needs the seller of a replacement inside the calendar, and the step-up hands the building to heirs who may not want it. The exit that fits is usually the one whose next buyer already exists.
What this does not mean
None of this is a recommendation to sell, exchange, or hold any particular property. The rates above are ceilings and thresholds; a household’s actual bill depends on its other income, on state tax, and on the building’s own history. An exchange defers tax rather than removing it. The step-up asks the owner to hold the property for life, a decision about how a household wants to live, not only about tax.
One combination does not exist. A like-kind exchange cannot be redirected into a Qualified Opportunity Fund: that election is available only for gain that “would be recognized,” and gain an exchange leaves unrecognized is not eligible (26 CFR §1.1400Z2(a)-1(b)(11)). Our work is to lay the three exits side by side, with the arithmetic for the actual building, and to coordinate the choice with the year’s income, the estate documents, and what the proceeds are for.
Frequently asked questions
Is depreciation taxed back even if I never claimed it?
Yes. The basis is reduced by the depreciation allowed, but not less than the amount allowable, so the sale is taxed as though the deduction had been taken each year (26 U.S.C. §1016(a)(2)). Missed deductions are a matter for the return, ideally before the sale.
Can I exchange a rental for stocks, a business, or an Opportunity Fund?
No. Since 2018 a like-kind exchange is limited to real property held for business or investment (IRS Instructions for Form 8824). An Opportunity Fund is a separate election for gain that would otherwise be recognized: an alternative to an exchange, not a destination for one.
If I exchange and then hold until death, what happens to the deferred gain?
The heirs take the property at its value on the date of death, and the recapture rules do not apply to a transfer at death (26 U.S.C. §1014(a)(1); §1250(d)(2)). The deferred gain and the depreciation history end with the owner.
I lived in the house before renting it. Does the home-sale exclusion still apply?
It can, in part. The home must have been the principal residence for two of the five years before the sale, the exclusion is prorated for periods of non-residence after 2008, and the depreciation portion is never excluded (26 U.S.C. §121(a), (b)(5), (d)(6)). The five-year clock makes this a question of timing.
Sources and further reading
- 26 U.S.C. §1(h): the 25 percent ceiling on unrecaptured section 1250 gain
- IRS Tax Topic 409, Capital gains and losses
- 26 U.S.C. §1031: like-kind exchanges of real property
- IRS Instructions for Form 8824, Like-Kind Exchanges
- 26 U.S.C. §1014: basis of property acquired from a decedent
- 26 U.S.C. §121: exclusion of gain on a principal residence
- 26 U.S.C. §1411: the 3.8 percent net investment income tax
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The views and opinions expressed here are those of The Financial Sciences Company as of the publish date and are provided for informational and educational purposes only. They are not personalized investment, tax, or legal advice. The Financial Sciences Company, LLC is a registered investment adviser. Registration does not imply a certain level of skill or training. Additional information is available in our Form ADV at adviserinfo.sec.gov.
General educational information, current as of 2026. Figures and rules change. For guidance specific to your situation, speak with a qualified professional.