A capital gain is the profit you realize when you sell a capital asset — such as a rental property — for more than your adjusted basis in that asset.
How it works: Your adjusted basis is generally the purchase price plus certain closing costs and improvements, minus any depreciation you've claimed. If you sell the property for more than that adjusted basis, the difference is a capital gain.
Short-Term vs. Long-Term
Long-term capital gains apply when you've held the property for more than one year. These are taxed at preferential rates (typically 0%, 15%, or 20%, depending on your income).
Short-term capital gains apply when you've held the property for one year or less. These are taxed as ordinary income, which can be significantly higher.
For Rental Property Owners
When selling a rental property, your gain may be split into two parts:
- Depreciation recapture — the portion attributable to depreciation you claimed, taxed at up to 25%.
- Capital gain — the remaining profit, taxed at long-term capital gains rates if held over one year.
A 1031 exchange can allow you to defer both the capital gain and depreciation recapture by reinvesting the proceeds into another investment property.