How to Avoid Capital Gains Tax on Sale of Rental Property [2026 Guide]
Six strategies to defer or eliminate capital gains tax when selling investment property, from 1031 exchanges to step-up basis planning.
Key Takeaway
One commonly used strategy to address capital gains tax when selling rental property is a 1031 exchange, which may allow investors to defer capital gains and depreciation recapture taxes by reinvesting proceeds into like-kind replacement property, subject to strict IRS requirements and deadlines. For investors seeking passive ownership, Delaware Statutory Trusts (DSTs) may qualify as 1031 replacement properties under certain conditions.
Individual tax situations vary significantly. This article provides general educational information only and does not constitute tax advice. Consult your CPA and tax advisor to evaluate which strategy, if any, is appropriate for your specific circumstances.
Selling a rental property can trigger a substantial tax bill, often catching investors off guard. Between federal capital gains tax, depreciation recapture, and state taxes, investors may face taxes of 25-40% of their gain. This guide explores several legal strategies that investors commonly use to potentially defer or reduce these tax obligations.
This guide covers six strategies that rental property investors may consider when selling. While a 1031 exchange is a commonly used option for many investors, each strategy has unique requirements and tax implications. Individual circumstances vary significantly, so investors should consult with their tax advisor and CPA to determine which approach, if any, is appropriate for their specific situation.
Understanding Capital Gains Tax on Rental Property Sales
When selling a rental property, investors typically face two distinct tax components that together can consume a significant portion of the profit. Understanding these components may help in evaluating potential tax strategies. Consult your tax advisor for guidance specific to your situation.
The Two-Part Tax Problem
Capital Gains Tax: This applies to the appreciation in your property's value. For 2026, long-term capital gains rates are 0%, 15%, or 20% depending on your taxable income. Single filers pay 0% up to $49,450, 15% from $49,451 to $545,500, and 20% above that. Married couples filing jointly have thresholds of $98,900 and $613,700 respectively.
Depreciation Recapture (The Hidden Tax): This is where many investors get surprised. Under IRC Section 1(h)(6), the IRS taxes all depreciation you claimed (or could have claimed) at a flat 25% rate, classified as "unrecaptured Section 1250 gain." This applies regardless of your income bracket and is in addition to capital gains tax on appreciation.
Example: The True Cost of Selling
Consider an investor selling a rental property for $800,000 with:
- Original purchase price: $500,000
- Depreciation claimed over 10 years: $145,000
- Adjusted basis: $355,000 ($500,000 - $145,000)
- Total gain: $445,000 ($800,000 - $355,000)
Tax breakdown (assuming 20% capital gains bracket):
- Depreciation recapture: $145,000 x 25% = $36,250
- Capital gains on appreciation: $300,000 x 20% = $60,000
- NIIT (if applicable): $445,000 x 3.8% = $16,910
- Federal taxes before state: $113,160
This example is for illustration only. Consult your CPA for calculations specific to your situation.
High earners also face the 3.8% Net Investment Income Tax (NIIT) on investment income above $200,000 (single) or $250,000 (married filing jointly). Combined with state taxes in places like California or New York, total tax rates can exceed 40% of your gain.
Strategy #1: 1031 Exchange (Defer 100% of Taxes)
A 1031 exchange is an IRS-approved strategy that may allow investors to defer both capital gains tax and depreciation recapture tax, subject to compliance with specific requirements. When properly structured, this strategy can enable investors to reinvest their equity into replacement property rather than paying taxes at the time of sale. Consult your tax advisor to determine if this strategy is appropriate for your situation.
How It Works
Under IRC Section 1031, if you sell investment real estate and reinvest the proceeds into "like-kind" replacement property, you can defer all capital gains taxes. Despite what the term suggests, "like-kind" has a broad definition for real estate: any real property held for investment or business use qualifies. You can exchange an apartment building for raw land, a rental house for a commercial property, or a single property for multiple replacement properties.
Critical Deadlines
45-Day Identification Period
You must formally identify potential replacement properties in writing within 45 calendar days of selling your property. This deadline is strict and cannot be extended for any reason. Learn more about navigating the 45-day identification period.
180-Day Exchange Period
You must close on your replacement property within 180 calendar days of selling your relinquished property (or by your tax return due date, whichever is earlier).
Qualified Intermediary Requirement
IRS regulations require that a Qualified Intermediary (QI) hold the sale proceeds during the exchange period. Direct receipt of proceeds by the taxpayer can disqualify the exchange. Learn how to choose a qualified intermediary. Your tax advisor can explain these requirements as they apply to your transaction.
DST Option for Passive Investors
For investors who want to exit active property management, Delaware Statutory Trusts (DSTs) qualify as replacement property under 1031 exchange rules. A DST allows you to own a fractional interest in institutional-quality real estate while a professional sponsor handles all property management. This option is particularly valuable for investors approaching retirement or those who no longer want landlord responsibilities.
1031 Exchange: What You Need to Know
- Defers both capital gains AND depreciation recapture taxes
- Must use a Qualified Intermediary (cannot touch proceeds)
- 45-day identification deadline is absolute
- 180 days to complete the exchange
- Can exchange into DSTs for passive ownership
- Can chain exchanges indefinitely throughout your lifetime
Strategy #2: Section 121 Primary Residence Conversion
Section 121 of the Internal Revenue Code provides for a potential exclusion of up to $250,000 of capital gains ($500,000 for married couples filing jointly) when selling a primary residence, subject to specific requirements. Some investors consider converting rental properties to primary residences to potentially access this exclusion, though the strategy has significant limitations and requirements.
Requirements
To potentially qualify for the Section 121 exclusion, taxpayers generally must have owned the property for at least two years AND used it as their primary residence for at least two of the five years before selling. The ownership and use periods do not need to be continuous or overlap. However, individual situations vary, and additional restrictions may apply. Consult your tax advisor to determine if you meet the requirements.
This strategy requires actually relocating to and living in the property for at least two years, which may be impractical for many investors, especially those with multiple properties or who live in a different geographic area. The personal and financial trade-offs should be carefully evaluated with professional guidance.
Strategy #3: Qualified Opportunity Zones
Qualified Opportunity Zones (QOZs) are a tax incentive program that may provide capital gains deferral and potential tax benefits on future appreciation for investments held 10 or more years, subject to compliance with specific requirements. This strategy was originally created by the Tax Cuts and Jobs Act of 2017 under IRC Section 1400Z-2, and was significantly updated by the One Big Beautiful Bill Act of 2025 (Opportunity Zones 2.0). Tax benefits depend on meeting all program requirements and are subject to change.
Current Rules (Through December 31, 2026)
Under the original QOZ rules, you have 180 days from realizing a capital gain to invest those gains into a Qualified Opportunity Fund (QOF). The original gain is deferred until December 31, 2026 (or earlier sale of the QOF investment). If you hold the QOF investment for at least 10 years, you can elect to step up your basis to fair market value at sale, meaning all appreciation on the QOF investment is tax-free.
Important Distinction
The 10-year tax-free benefit applies only to NEW appreciation on your QOF investment, not your original deferred gain. Under current rules, the original capital gain you rolled into the QOZ must be recognized by December 31, 2026, regardless of how long you hold the QOF investment.
Opportunity Zones 2.0 (Starting January 1, 2027)
The One Big Beautiful Bill Act of 2025 enacted "Opportunity Zones 2.0," which introduces significant changes effective January 1, 2027. The Treasury Department will designate new qualified opportunity zones, and existing zone designations will be replaced.
Key Changes Under Opportunity Zones 2.0
- 5-Year Rolling Deferral: The fixed December 31, 2026 recognition deadline is replaced with a 5-year rolling deferral period. Investors can defer their original capital gain for up to 5 years from the date of investment, rather than facing a fixed cliff date.
- 30% Basis Step-Up at Year 5: Investors who hold QOF investments for at least 5 years receive a 30% basis step-up on their original deferred gain. This replaces the previous structure of 10% at 5 years and 15% at 7 years.
- 10-Year Tax-Free Appreciation Continues: The benefit of tax-free appreciation on new gains for investments held 10 or more years remains intact.
- New Zone Designations Required: All zones will be redesignated under new criteria. The qualification threshold tightens from 80% to 70% of median income for eligible census tracts.
- Enhanced Rural Benefits: Rural opportunity zones receive favorable treatment, including a reduced substantial improvement threshold of 50% (versus 100% for other zones).
QOZs may be suitable for investors interested in specific geographic areas, though they are less flexible than 1031 exchanges since investments must be in designated opportunity zone census tracts. The 2027 changes may enhance the program's attractiveness by eliminating the 2026 cliff and providing a more generous basis step-up. Compare the differences between 1031 exchanges, DSTs, TICs, and QOZs to better understand each structure. Consult your tax advisor to determine if QOZ investments are appropriate for your situation.
Anchor1031 expects to offer Qualified Opportunity Zone investments in our marketplace starting in 2027, potentially giving investors access to vetted QOF opportunities alongside our existing DST offerings.
Strategy #4: Installment Sales
An installment sale under IRC Section 453 may allow spreading capital gains recognition across multiple tax years when the buyer pays over time rather than in a lump sum. Under this structure, gain is typically recognized proportionally as payments are received.
This approach can potentially result in lower effective tax rates if it keeps the seller in lower tax brackets each year, though this depends on individual circumstances. However, installment sales do not eliminate taxes—they spread them over time. Additionally, interest income from seller financing is generally taxed as ordinary income, which may be at higher rates than capital gains. Tax implications vary by individual situation.
Installment sales involve risks: if the buyer defaults, the seller may have already paid taxes on payments never received. IRS regulations generally do not permit combining installment sales with 1031 exchanges. Consult your tax advisor and attorney before pursuing this strategy.
Strategy #5: Tax-Loss Harvesting
Tax-loss harvesting involves using investment losses to potentially offset capital gains. When investors have stocks, bonds, or other investments that have declined in value, selling them in the same tax year as a rental property sale may create losses that could reduce taxable gains, subject to IRS limitations.
This strategy requires having losses available in the portfolio and depends on individual tax circumstances. It generally does not address depreciation recapture, which is typically taxed separately under different rules. Investors should be aware of wash sale rules under IRC Section 1091, which may disallow losses if substantially identical securities are repurchased within 30 days before or after the sale.
Under current tax law, excess capital losses beyond capital gains can generally offset up to $3,000 of ordinary income per year, with remaining losses typically carried forward to future years. Rules and limitations vary by individual circumstances. Consult your tax advisor for guidance specific to your situation.
Strategy #6: Hold Until Death (Step-Up Basis)
Under current tax law, IRC Section 1014 provides for a "stepped-up basis" to fair market value for property received from a decedent. This can potentially eliminate both capital gains and depreciation recapture taxes for heirs, though tax laws are subject to change. The application of this provision depends on various factors including estate size, state law, and tax law changes.
Some estate planning strategies combine 1031 exchanges during the investor's lifetime with step-up basis planning. However, this approach involves complex estate and tax considerations. Investors should work closely with their estate planning attorney, CPA, and financial advisors to evaluate whether this strategy aligns with their specific goals and circumstances.
This strategy has trade-offs: accessing equity during the investor's lifetime would typically trigger tax obligations. Whether this approach is suitable depends on the investor's overall financial situation, liquidity needs, and estate planning objectives. Consult your financial and tax advisors to evaluate if this strategy fits your circumstances.
Comparing All 6 Strategies
| Strategy | Tax Benefit | Key Requirement | Best For |
|---|---|---|---|
| 1031 Exchange | Defer 100% (gains + recapture) | Reinvest in like-kind property | Investors staying in real estate |
| Section 121 | Exclude up to $500K gains (not recapture) | Live in property 2+ years | Investors willing to relocate |
| Opportunity Zones | Defer gains (5 yrs) + 30% basis step-up + tax-free appreciation (10 yrs) | Invest in QOZ fund in designated area | Investors targeting specific areas |
| Installment Sale | Spread gains across years | Seller financing arrangement | Sellers wanting income stream |
| Tax-Loss Harvesting | Offset gains dollar-for-dollar | Have losses available | Investors with losing positions |
| Hold Until Death | Eliminate 100% for heirs | Hold until passing | Estate planning focused investors |
How Anchor1031 Helps Investors Defer Capital Gains
If you are researching how to address capital gains tax when selling rental property, you are likely evaluating whether to reinvest, cash out, or explore passive alternatives. Many investors consider 1031 exchanges as a tax deferral strategy, though the process involves complexity and strict deadlines that require careful planning. Individual results vary based on specific circumstances, and investors should consult their tax advisor to evaluate their options.
Anchor1031 specializes in helping investors explore 1031 exchanges into Delaware Statutory Trusts (DSTs), which may provide a way to defer capital gains and depreciation recapture taxes (subject to IRS requirements) while exiting active property management. Here is how we help:
What Anchor1031 Provides
DST Marketplace Access
Browse vetted DST offerings across multiple asset classes with detailed due diligence materials.
1031 Exchange Coordination
We work with your Qualified Intermediary and coordinate deadlines so you do not miss the 45-day identification or 180-day exchange windows.
Property Due Diligence
Our designated broker-dealer analyzes sponsor track records, property financials, and market conditions to help you evaluate replacement property options.
Backup Strategy Planning
Tight deadlines create risk. We help you identify multiple properties and develop contingency plans. Learn about 1031 backup strategies.
Whether you want to stay invested in real estate while eliminating landlord responsibilities, or you are simply exploring your options, our team can walk you through the process and help you understand what strategies may be available. We do not provide tax or legal advice; investors should consult their CPA and attorney to determine what approach is appropriate for their specific situation.
Frequently Asked Questions
How much capital gains tax will I pay when I sell my rental property?
Rental property investors may face combined federal taxes of approximately 25-40% when selling, depending on individual circumstances. This can include federal capital gains tax (0-20% depending on income level), depreciation recapture tax (25% rate on certain gains), Net Investment Income Tax (3.8% for certain high-income taxpayers), and applicable state taxes. Tax liability varies significantly based on individual factors including income level, holding period, depreciation taken, and state of residence. This example is for illustration only. Consult your CPA for calculations specific to your situation.
Can I avoid capital gains tax on rental property without buying another property?
Potentially, but options are limited. Strategies that do not require purchasing replacement property include tax-loss harvesting (if you have investment losses), installment sales (spreads tax over time but does not eliminate it), and holding until death (step-up basis). However, a 1031 exchange remains one of the most effective strategies for most investors, and Delaware Statutory Trusts (DSTs) allow you to complete a 1031 exchange without the responsibilities of direct property ownership. Investors should consult with their CPA and tax advisors to determine the best approach for their situation.
What is the 45-day rule for avoiding capital gains tax?
The 45-day rule refers to the 1031 exchange identification period. According to Anchor1031, after selling your rental property, you have exactly 45 calendar days to formally identify potential replacement properties in writing to your Qualified Intermediary. This deadline is strict and cannot be extended for any reason, including weekends or holidays. Missing this deadline disqualifies your exchange entirely.
Do I pay capital gains on rental property I have owned for 20 years?
Yes, long-term ownership does not exempt you from capital gains tax. In fact, properties owned for decades typically have larger tax bills due to significant appreciation and accumulated depreciation recapture. According to Anchor1031, this makes 1031 exchanges particularly valuable for long-term property owners, as they can defer substantial tax liabilities indefinitely while reinvesting their full equity into replacement property.
Can I do a 1031 exchange into a rental property I want to live in later?
Yes, but with important restrictions. According to Anchor1031, IRS Revenue Procedure 2008-16 establishes a safe harbor requiring you to rent the replacement property for at least 24 months (14+ days per year at fair market rent) and limit personal use to 14 days or 10% of rental days before converting to personal use. Additionally, you cannot claim the Section 121 primary residence exclusion for 5 years after the exchange. Consult your tax advisor before planning this strategy.
What happens if I do not reinvest proceeds from selling rental property?
If proceeds are not reinvested using a 1031 exchange or another tax-deferral strategy, taxpayers generally owe capital gains tax plus depreciation recapture tax in the year of sale. Combined tax liability often amounts to 25-40% or more of the total gain, depending on individual circumstances. For investors who have held property for many years, this can result in substantial tax bills. Individual tax outcomes vary based on numerous factors. Consult your CPA to understand the potential tax implications of your specific transaction.
Bottom Line
Selling a rental property often involves significant tax considerations. The 1031 exchange is one strategy that many investors consider because it may defer both capital gains and depreciation recapture taxes (subject to compliance with IRS requirements) while keeping capital invested in real estate.
For investors who want to exit active management, DSTs may provide an option to complete a 1031 exchange into professionally managed, institutional-quality properties. For those focused on estate planning, some advisors recommend combining 1031 exchanges during the investor's lifetime with step-up basis planning, though this involves complex tax and estate considerations.
The appropriate strategy depends on individual goals, timeline, and tax situation. Every investor's circumstances are different. Consult your CPA, tax advisor, and legal counsel to evaluate your options before your sale closes. This article is for educational purposes only and does not constitute tax or legal advice.
About the Author
Trevor Sybertz, Partner
Trevor Sybertz is a Partner at Anchor1031, where he specializes in educating clients about 1031 exchanges, private real estate offerings, and REITs. With over a decade of experience in commercial real estate and capital markets, Mr. Sybertz has helped clients invest more than $100M in equity across a wide range of real estate assets and markets. Previously, he served as a Director at RealtyMogul, and before that as Assistant Vice President of Institutional Equity Sales at Keefe, Bruyette & Woods where he covered commercial mortgage REITs and international equities.
Sources
This article references the following IRS publications and Internal Revenue Code sections:
1031 Exchanges:
- 26 U.S.C. Section 1031 (Cornell Law)
- IRS Like-Kind Exchanges Guide
- Treasury Reg. Section 1.1031(k)-1 (QI Requirements)
Capital Gains Tax Rates:
Depreciation Recapture:
- 26 U.S.C. Section 1(h) - Rate limitations including 25% unrecaptured Section 1250 gain
- 26 U.S.C. Section 1250 - Section 1250 property definition
Primary Residence Exclusion:
Qualified Opportunity Zones:
- 26 U.S.C. Section 1400Z-2 (Cornell Law)
- IRS Opportunity Zones FAQ
- One Big Beautiful Bill Act of 2025 - Opportunity Zones 2.0 provisions (effective January 1, 2027)
Step-Up Basis:
- 26 U.S.C. Section 1014 (Cornell Law)
Safe Harbor for Dwelling Units:
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Disclosure
Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.