Definition
Capital gains are the profits you realize when you sell a property (or another investment) for more than its adjusted basis. In real estate, gain is typically measured after transaction costs (broker fees, closing costs) and is influenced by depreciation, which reduces basis over time.
How Capital Gains Are Calculated
A simple way to think about it: you compare your net sale proceeds to what you have “in the deal†for tax purposes (your adjusted basis).
Common formula
- Capital Gain = Net sale price (sale price − selling costs) − Adjusted basis
Short-Term vs. Long-Term
Capital gains are commonly categorized by holding period:
- Short-term capital gain: generally applies when an asset is held for a shorter period and is often taxed at ordinary income rates.
- Long-term capital gain: generally applies when an asset is held longer and is often taxed at preferential rates.
For investors, the holding period can materially affect after-tax returns and is often considered in the exit strategy.
Depreciation and Depreciation Recapture
Depreciation lowers your adjusted basis, which can increase your gain on sale. In many cases, part of the gain may be treated as depreciation recapture, which can be taxed differently than the remaining long-term capital gain portion.
Why It Matters
- After-tax returns: capital gains taxes can materially change your net profit and IRR.
- Disposition timing: timing a sale can change tax rates and outcomes.
- Underwriting accuracy: realistic exit proceeds require modeling selling costs and tax impact (at least at a high level).
- Strategy selection: value-add and short hold periods can increase taxable gain velocity.
Example
You purchase a property for $1,000,000, complete $150,000 in capital improvements, and take $220,000 in cumulative depreciation. Your adjusted basis is:
- Adjusted basis = 1,000,000 + 150,000 − 220,000 = $930,000
You sell the property for $1,250,000 and pay $75,000 in selling costs. Net sale proceeds are:
- Net sale proceeds = 1,250,000 − 75,000 = $1,175,000
- Capital gain = 1,175,000 − 930,000 = $245,000
Depending on facts and tax rules, part of this gain may be treated as depreciation recapture.
Common Planning Strategies (High Level)
- 1031 exchange: defer recognized gain by reinvesting proceeds into like-kind real estate.
- Installment sale / seller financing: potentially spread recognized gain over time (subject to rules).
- Harvesting losses: offset gains with losses from other investments where permitted.
- Basis tracking: maintain CapEx and improvement records to support basis and reduce taxable gain.
Common Pitfalls
- Ignoring selling costs: underwriting “sale price†instead of net proceeds overstates gains and proceeds.
- Confusing repairs vs. CapEx: only certain improvements increase basis.
- Forgetting depreciation effects: depreciation lowers basis and can increase gain and recapture on sale.
- Assuming taxes are “someone else’s problemâ€: taxes affect net distributions and investor returns.
Related Terms
Note: This glossary entry is for education only and is not tax, legal, or accounting advice. Tax outcomes vary by jurisdiction and by investor. Consult qualified professionals for your specific situation.