How your gain is calculated
Your taxable gain is roughly your sale price minus selling costs minus your adjusted cost basis. The adjusted basis starts at your purchase price, rises with capital improvements, and (this is the part that surprises people) falls with every year of depreciation you claimed. A rental owned for fifteen years can carry a large gain even if the market price barely moved, because depreciation quietly lowered the basis the whole time.
Long-term vs. short-term rates
Hold a property for more than one year and the gain is long-term; hold it one year or less and the gain is short-term, taxed as ordinary income. Long-term rates depend on your income; 15-20% for most real estate investors.
| Tax | Applies to | Rate |
|---|---|---|
| Long-term capital gains | Property held more than one year | 0% / 15% / 20% |
| Short-term capital gains | Property held one year or less, taxed as ordinary income | Up to 37% |
| Depreciation recapture | Depreciation claimed during ownership, on top of the capital gains rate | Up to 25% |
Short-term gains are also not the target of a 1031 exchange strategy; the deferral shines on long-held, well-appreciated property. More on the long-term vs. short-term comparison.
What a 1031 exchange changes
Through a 1031 exchange, the tax on your gain (capital gains and depreciation recapture alike) is deferred, and the entire proceeds reinvest into replacement property, compounding in the new property.
Deferred: not forgiven, but powerful
The deferred gain carries into your new property’s basis, and exchanges can be repeated indefinitely as you trade up. Held to death, heirs currently receive a stepped-up basis, the strategy investors call “swap till you drop.”