Rental and second homes: the tax when you sell

A rental property or a vacation home can be a real asset in retirement: extra income, a place to escape to, maybe something to pass on to your family. When the time comes to sell, though, the tax bill often comes as a surprise.

That's because the generous tax break for selling your home only covers the home you live in. Here's what to expect, and the most common ways people lower or delay the bill.

What you can expect to owe

When you sell a rental or second home, your whole profit can be taxed. Your profit is the sale price, minus your selling costs, minus your basis (roughly what you paid plus major improvements).

If you rented the property out, part of that profit is taxed differently. Here's why. Each year you owned it as a rental, you were allowed to deduct part of the building's cost on your taxes, as if the building were slowly wearing out. This is called depreciation. It lowered your taxes along the way. When you sell, the IRS takes some of that benefit back: the part of your profit that comes from depreciation is taxed at up to 25%. (This applies whether or not you actually claimed the deduction, if you were entitled to it.)

The rest of the profit is taxed at long-term capital gains rates, which are lower than regular income tax rates: 0%, 15% or 20%, depending on your income. In 2026, a married couple doesn't reach the 20% rate until their taxable income passes $613,700.

Higher earners may also owe an extra 3.8%, called the net investment income tax. It applies to people with income above $250,000 for a married couple, or $200,000 for a single person. And most states tax the profit too.

Ways to lower or delay the bill

A 1031 exchange: swap instead of sell. Named after Section 1031 of the tax code, this lets you sell an investment property and use the money to buy another one, without paying tax on your profit yet. The tax isn't forgiven. It's carried over to the new property and comes due when you eventually sell that one. People often use exchanges to trade a property that's a lot of work for one that's easier to manage.

The rules are strict, so you'll need help:

• You can't touch the money in between. A neutral company called a qualified intermediary holds it.
• You have 45 days after the sale to name the property you want to buy, and 180 days to complete the purchase.
• It only works for investment or business property, not a home you live in.

Keeping the property for life. This one surprises people. When you pass away, your heirs generally inherit the property at its value on the day you died, a rule called a step-up in basis. All the growth in value during your lifetime, including the depreciation, is wiped clean for tax purposes. If your heirs sell soon after, there's little or no profit to tax. For some families this saves more than anything else. The trade-off, of course, is that you don't get to use that money yourself.

Spreading the sale over time. In an installment sale, the buyer pays you over several years instead of all at once, and you pay tax on your profit as the money comes in. Spreading it out can keep more of it in lower tax brackets. The risk is that you're counting on the buyer to keep paying.

Moving in before you sell. If you make the property your main home for at least two years before selling, part of your profit can use the home-sale tax break (up to $500,000 for a married couple). There's a catch, though. Years it was a rental after 2008 count against you, in proportion. For example, if you owned the property for 17 years, rented it out for the first 15 and lived there for the last 2, only about 2 of those 17 years count in your favor, so roughly 12% of the profit would qualify. The part from depreciation is always taxed. And this only works if it truly becomes your home, not just on paper.

A word of caution about "packaged" investments

If you're considering a 1031 exchange, you may be offered a share in something called a Delaware statutory trust, or DST. It's a way to own a slice of a large property, like an apartment complex, without managing it yourself. It can work for some people, but it's a specialized investment. You may not be able to sell your share when you need the money, the fees can be high, and the income isn't guaranteed. Please get independent advice from someone who isn't selling it before you commit.

Before you sell

Gather your purchase papers, records of any improvements, and the depreciation shown on your past tax returns. Then sit down with a tax preparer and compare selling outright with the options above. If you're planning to sell more than one property, ask about the order too. The home-sale break can only be used once every two years, so the sequence can matter.