- 01Depreciation recapture hits at a flat 25% rate when you sell — on a property with $45,000 in claimed depreciation, that's $11,250 the IRS takes back
- 02Flips held under 12 months are taxed as ordinary income — at the 32% bracket, an $80,000 profit becomes a $25,600 tax bill
- 03The 3.8% Net Investment Income Tax kicks in above $200K AGI for single filers — an invisible surcharge that stacks on top of capital gains
- 04A 1031 exchange defers all three traps simultaneously — you roll the proceeds into the next property and the tax clock resets
- 05Installment sales spread the gain across multiple years, potentially keeping you in lower brackets each year
Show Notes
You bought a rental in Memphis for $200,000. Held it for six years. Collected rent. Claimed your depreciation like a good investor — $7,273 a year, $43,636 total. The market moved. You sold for $280,000.
So you made $80,000. Nice payday, right?
Then the closing statement hits. And you don't owe taxes on just the $80,000 gain. You owe on the $80,000 plus the $43,636 in depreciation you claimed. Your taxable event is $123,636. Depending on your bracket, the IRS takes somewhere between $23,000 and $30,000.
That's not a surprise you want at the closing table. Let's talk about the three traps — and how to sidestep every one of them.
Trap #1: Depreciation Recapture — The Clawback
[1:15]
Depreciation is the best tax break in real estate. The IRS lets you deduct a portion of your property's value every year — roughly 3.636% of the building's cost (land excluded) over 27.5 years. On that $200,000 Memphis rental with a $160,000 building value, that's $5,818 a year in phantom losses. Money the IRS pretends you lost, even though the property probably went up in value.
Beautiful while you're holding. Painful when you sell.
Here's the catch: when you sell, the IRS wants that depreciation back. Every dollar you claimed gets "recaptured" and taxed at a flat 25% rate. Not your ordinary income rate. Not capital gains. A flat 25% — no negotiation.
On our Memphis property, you claimed $43,636 over six years. At 25%, that's $10,909 in recapture tax. Before you even touch the capital gains calculation — $10,909 is already gone.
And here's what trips people up — you owe depreciation recapture even if you didn't actually claim the deduction. The IRS taxes you on the depreciation you were allowed to claim, whether you took it or not. So if your accountant missed it for three years, you still owe recapture on the full amount. The deduction is use-it-or-lose-it, but the recapture is mandatory.
That's why I tell every investor: claim your depreciation. Every year. You're going to pay the recapture either way. Might as well take the tax savings while you're holding.
Trap #2: Short-Term Capital Gains — The Flip Tax
[3:00]
This one catches flippers hard.
If you sell a property you've held for less than 12 months, the profit isn't taxed at the capital gains rate. It's taxed as ordinary income. At your marginal rate. For a lot of active investors, that's the 32% bracket — or higher.
Say you flip a house in Cleveland. Bought for $118,000, put $42,000 into the rehab, sold for $240,000. Your profit: $80,000. Held it 10 months? That $80,000 gets stacked on top of your W-2 income and taxed at your ordinary rate.
At the 32% bracket: $25,600 in federal tax.
If you'd held it 13 months instead of 10? Long-term capital gains rate: 15%. Tax bill: $12,000. Three months. $13,600 saved. That's it.
Absurd? Yes. But the IRS doesn't care about your timeline. They care about the calendar. Under 12 months = ordinary income. Over 12 months = capital gains.
So if you're anywhere near the 12-month mark — hold. Even if it means carrying the property a few extra months. The tax savings almost always crush the carry costs.
Trap #3: Net Investment Income Tax — The Stealth Surcharge
[4:15]
This one sneaks up on you. The Net Investment Income Tax — NIIT — is a 3.8% surcharge on investment income for single filers above $200,000 AGI, married filers above $250,000.
That includes rental income. Capital gains. Interest. Dividends. All of it.
So go back to our Memphis sale. You've got $80,000 in capital gains and $43,636 in depreciation recapture. If your AGI with those gains pushes above $200,000, the IRS tacks on 3.8% of the excess.
Say your AGI lands at $280,000. The amount above the $200K threshold is $80,000. The NIIT is 3.8% of $80,000: $3,040. On top of the capital gains tax. On top of the depreciation recapture.
Stack all three together on our Memphis deal:
- Depreciation recapture: $10,909
- Long-term capital gains (15% on $80,000): $12,000
- NIIT (3.8% on $80,000): $3,040
- Total tax hit: $25,949
You sold for an $80,000 gain and kept $54,051. The IRS took 32.4%. And that's the long-term rate. Flip it in under 12 months? Closer to $30,000+ gone.
The Escape Routes
[5:15]
You don't have to eat those taxes. Three legal ways around them.
The [1031 exchange](/glossary/1031-exchange). This is the big one. Sell your property and reinvest the proceeds into a "like-kind" replacement property within 180 days. The capital gains, the depreciation recapture, and the NIIT all get deferred. You don't pay until you sell the replacement property — and if you 1031 again, the clock resets again. Chain enough 1031s together and you can defer taxes for decades.
Rules are strict. You've got 45 days to identify replacement properties and 180 days to close. A qualified intermediary holds the funds — you can never touch the money. But the tax savings are enormous. On our Memphis deal, that's $25,949 you keep working for you instead of going to the IRS.
Our portfolio scaling guide breaks down the full 1031 process, including timelines, identification rules, and the boot trap.
The installment sale. Instead of collecting the full sale price at closing, you structure seller financing. The buyer pays you over 5, 10, or 15 years. Your capital gain is spread across each year you receive payment, keeping you in lower tax brackets. If you can stay under the $200K AGI threshold in each year, you dodge the NIIT entirely.
Opportunity zones. Invest your capital gains into a qualified opportunity zone fund within 180 days of the sale. The original gain is deferred until 2026 (or when you sell the OZ investment). If you hold the OZ investment for 10+ years, any new appreciation is completely tax-free.
The Full Picture: Know Your Numbers Before You Sell
[6:30]
Run the tax math before you list the property. Not after. Here's the calculation on one page:
- Sale price minus purchase price = capital gain
- Total depreciation claimed = recapture amount
- Recapture × 25% = recapture tax
- Capital gain × 15% (or 20% if high income) = capital gains tax
- If AGI > $200K: excess × 3.8% = NIIT
- Total: recapture + capital gains + NIIT
If that number makes you flinch, explore a 1031 exchange before you list. The exit strategy isn't something you figure out at closing. You plan it at purchase.
The tax strategy guide walks through depreciation schedules, cost segregation, and every exit strategy in detail. And keep your NOI and cash flow numbers clean — they're the foundation for every tax decision you'll make.
Talk to your CPA. Show them this episode. And run the numbers before the IRS does it for you.
The ratio of a loan amount to a property's appraised value, expressed as a percentage — a 75% LTV on a $200,000 property means a $150,000 loan and $50,000 in equity.
Read definition →A ratio that measures whether a rental property's income covers its debt payments — calculated by dividing rental income by total debt service (PITIA), where 1.0 means breakeven and 1.25+ means strong cash flow.
Read definition →A short-term, asset-based loan from a private lender, typically used to finance property acquisitions and renovations at higher interest rates than conventional mortgages, with the property itself as collateral.
Read definition →Conditions in a purchase contract that must be met for the deal to close. If they're not satisfied, you can walk away—and usually get your earnest money back.
Read definition →A deposit you put down when your offer is accepted—to show you're serious. It's held in escrow until closing and typically refundable if you back out for a valid reason under your contingencies.
Read definition →
