When you sell a rental property for more than your adjusted cost basis, the profit is a capital gain subject to federal (and sometimes state) capital gains tax. The holding period determines the tax rate. If you held the property one year or less, the gain is short term and taxed as ordinary income at rates up to 37% federal. If you held more than one year, the gain is long term and taxed at the preferential rates of 0%, 15%, or 20% depending on your total taxable income. On top of capital gains tax, you also owe depreciation recapture (up to 25%) on the total depreciation you claimed during the hold period, calculated separately. State capital gains taxes vary widely; some states (Florida, Texas, Washington, Wyoming) have no state capital gains tax, others can add 5% to 13%. The only way to fully defer capital gains tax is through a 1031 exchange into a replacement investment property, or by dying with the property in your estate (which gives heirs a stepped up basis and eliminates the tax entirely). Understanding capital gains is essential for sell versus hold decisions and for tax planning around property sales.
Example
Sale price $300,000. Original purchase price $180,000. Capital improvements $25,000. Depreciation claimed $35,000. Selling costs $18,000. Adjusted basis = 180,000 + 25,000 - 35,000 = $170,000. Capital gain = 300,000 - 170,000 - 18,000 = $112,000. Plus $35,000 of depreciation recapture taxed separately at 25%.