When you sell your rental property, you will incur federal and state capital gains taxes. Capital gain is the difference between your selling price and your adjusted tax basis. The IRS classifies capital gains as either short- or long-term. Gain on the sale of property held for one year or less is considered short term and is taxed at your ordinary income tax rate. Gain on sale of property held for more than one year is classified as a long-term capital gain and is taxed at rates ranging from 0 percent to 20 percent. Most homeowners will pay at the 15 percent rate.
IRS regulations generally require that you depreciate your rental property over 27.5 years, or 3.636 percent per year. To calculate your depreciation deductions, we assume that your $400,000 purchase price was allocated between the land valued at $100,000 and the improvements valued at $300,000. You stated you made no other capital improvements. So, you were able to take $10,908 annual depreciation expense deductions on your tax return (3.636 percent X $300,000) for each full year you rented it. This non-cash tax deduction reduced your taxes on an annual basis. But now that you are selling, this non-cash tax deduction must be paid back in part, as depreciation recapture tax.
Because land does not wear out, the IRS does not permit you to depreciate the purchase price attributable to the land. When you apply the 3.636 percent annually against your $300,000 depreciable basis for your 10-year holding period, you have taken $109,080 in accumulated depreciation deductions. That amount will now be “recaptured” and taxed at the 25 percent tax rate. So, in addition to your capital gains tax, you will incur $27,270 in depreciation recapture tax.