Capital Gains Tax on Rental Property

A landlord who has collected rent on a Queens two-family or a Westchester duplex for years is usually surprised by two things when they finally sell: the recapture bill and the New York state bill. Both apply on top of the federal capital gains tax, and neither shows up in the simple math of sale price minus purchase price. Understanding what actually gets taxed, and at what rate, changes how a seller should be thinking about the transaction months before it closes.

The taxable gain isn't sale price minus what was originally paid. It's sale price minus adjusted basis, and adjusted basis is the purchase price plus capital improvements minus accumulated depreciation claimed over the years the property was rented. Every year a landlord depreciated the building on their tax return lowered that basis, which means the eventual gain is larger than a simple appreciation calculation would suggest, sometimes substantially so on a property held for a decade or more.

This is the piece that catches long-term rental owners off guard. A property that only rose modestly in market value can still produce a large taxable gain once years of depreciation deductions are subtracted from the basis.

The portion of the gain attributable to depreciation already claimed is taxed separately from the rest of the capital gain, at a federal rate capped at twenty-five percent rather than the standard long-term capital gains rates. This is depreciation recapture, and it applies whether or not the owner actually benefited from the deductions in a given year. It's owed on the depreciation that was allowed, not just the depreciation that was used to reduce taxable income.

New York does not have a separate recapture category at the state level. Both the recapture portion and the remaining capital gain get taxed as ordinary income on the state return, which is a different structure than the federal split and one more reason the state bill often surprises sellers who only budgeted around the federal numbers.

Rental property held more than a year qualifies for long-term capital gains treatment on the non-recapture portion of the gain, at federal rates well below ordinary income brackets. Property held a year or less is taxed at short-term rates, which match ordinary income tax brackets and can be significantly higher. New York doesn't distinguish between short-term and long-term at the state level; both are taxed the same way as ordinary income regardless of how long the property was held.

A 1031 exchange defers both the capital gains portion and the depreciation recapture portion of the tax, as long as the proceeds move into another qualifying rental or investment property through a qualified intermediary. This is different from a primary residence sale, where recapture on rental use during ownership still applies even if part of the gain qualifies for the home sale exclusion.

For a landlord planning to keep operating rental property rather than exit real estate entirely, exchanging into a new asset postpones both tax layers rather than settling one and deferring the other.