Capital Gains Tax on Rental Property

Capital gains tax on rental property works differently than the tax on a primary residence, mainly because of two things a homeowner never has to think about: depreciation recapture and the loss of the Section 121 exclusion. A Newport Beach owner who has rented out a Balboa Island cottage or a Corona del Mar duplex for years is likely to owe more in combined tax than the sale price minus purchase price might suggest, once depreciation is factored back in.

The taxable gain starts with the adjusted basis, which is the original purchase price plus capital improvements, minus all depreciation claimed over the ownership period, even if some of it was never actually deducted on a return. That last part surprises owners who skipped depreciation in some years; the IRS generally requires recapture on allowed depreciation whether or not it was claimed, a rule sometimes called allowed-or-allowable.

Once basis is established, the gain is split into two pieces for tax purposes: the portion equal to depreciation taken, which is recaptured at a rate up to 25%, and the remaining appreciation, which is taxed at long-term capital gains rates if the property was held more than a year.

Federal long-term capital gains rates run 0%, 15%, or 20% depending on income, with an additional 3.8% net investment income tax for higher earners. California does not have a separate capital gains rate; the gain is added to ordinary income and taxed at the state's regular brackets, which can reach 13.3% for the highest earners. For a Newport Beach rental sale with substantial appreciation, this state layer is often larger than sellers expect coming from a state with a capital gains preference.

The Section 121 exclusion requires the property to have been used as a primary residence for two of the last five years. A rental that has never served as the owner's residence does not qualify at all. Some owners convert a former rental into a primary residence for a period before selling, which can partially restore access to the exclusion, but the calculation is prorated based on the years of rental versus residential use, and the depreciation recapture portion still does not qualify for the exclusion regardless of how the property was later used.

Because a rental is investment property, it is eligible for a 1031 exchange, which defers both the capital gains tax and the depreciation recapture by rolling the proceeds into a replacement property of equal or greater value. This does not erase the gain; it carries the deferred amount forward into the new property's basis, and it requires a qualified intermediary and the 45-day and 180-day exchange deadlines to be met. An installment sale is another option when a buyer is willing to pay over time, spreading the recognized gain, and by extension the tax, across multiple years instead of the year of sale.

A landlord deciding between selling a Newport Beach rental outright and exchanging into another property should look at the full picture before signing a listing agreement, not after an offer has already been accepted. Once a sale closes without a qualified intermediary in place, the option to defer through a 1031 exchange is gone entirely; there is no way to retroactively add exchange treatment to a transaction that has already funded. Landlords who are even considering an exchange should have a qualified intermediary lined up before the property goes under contract, so the paperwork can be built into the purchase agreement from the outset rather than added under time pressure.