A landlord selling a rental in the Louisville area usually has two numbers to reckon with, not one: the capital gains tax on rental property appreciation, and a separate depreciation recapture bill on every year the property was rented out. Both come due in the same tax year unless the sale is structured to defer them.
Two Taxes, Not One
The appreciation portion, the difference between the adjusted basis and the sale price, is taxed at long-term capital gains rates if the property was held over a year. The depreciation portion is taxed separately as depreciation recapture, currently capped at a 25% federal rate, because the IRS is effectively reclaiming the tax benefit the deductions provided during the ownership period.
An owner who has depreciated a duplex on Bardstown Road for a decade should expect the recapture bill to be a meaningful part of the total tax owed at closing, sometimes larger than the appreciation gain itself on a property that hasn't moved much in price.
How the Numbers Get Calculated
Adjusted basis starts at purchase price, adds capital improvements, and subtracts total depreciation claimed. Sale price minus adjusted basis equals total gain. From there, the portion equal to depreciation claimed is taxed as recapture, and whatever remains is taxed as capital gain. Missing depreciation schedules from a previous accountant is a common and expensive problem here, since the IRS calculates recapture on depreciation allowed or allowable, whether or not it was actually claimed on past returns.
State Tax on Top of Federal
Kentucky does not have a separate capital gains rate; the gain is added to ordinary income and taxed at the state's flat rate. A landlord selling a rental in Jeffersontown or St. Matthews should factor that state liability into the total bill rather than only budgeting for the federal side.
Deferring Both Taxes With a 1031 Exchange
A 1031 exchange defers both the capital gains and the depreciation recapture on rental property, as long as the proceeds move into a like-kind replacement within the required identification and closing windows. It's a deferral rather than a forgiveness of either tax, and it only works for property held for investment or business use, not a rental converted to a personal vacation home shortly before the sale.
What a Landlord Should Pull Together Before Listing
A clean set of depreciation schedules from every year the property was rented, a running list of capital improvements separate from routine repairs, and closing statements from the original purchase give a landlord and their accountant enough to estimate both the recapture and the appreciation gain before an offer even comes in. Waiting until after an accepted offer to gather this documentation tends to compress an already tight closing timeline, and it can also foreclose a 1031 exchange as an option if the qualified intermediary isn't engaged before the relinquished property closes.
A landlord selling a rental near Okolona or Valley Station who's unsure whether the numbers favor a straight sale, an installment sale, or an exchange is usually better served running the comparison with an accountant before listing than after, since some of these strategies require steps taken before the closing rather than after.
Common 1031 Exchange Questions
Is depreciation recapture always taxed separately from capital gains?
Yes. Recapture on real property is capped at a 25% federal rate under unrecaptured Section 1250 rules, while the remaining gain above the depreciated amount is taxed at ordinary long-term capital gains rates, which top out lower for most sellers.
What if I never claimed depreciation on my rental?
The IRS calculates recapture based on depreciation allowed or allowable, meaning the tax applies whether or not it was actually claimed on past returns. Skipping depreciation deductions over the years does not avoid the recapture tax at sale.
Does converting a rental to my primary residence avoid this tax?
It can reduce it under certain rules, but converted property is subject to a nonqualified use calculation that limits how much of the gain qualifies for the primary residence exclusion, based on the ratio of rental years to total ownership years.
Can I do a partial 1031 exchange on a rental sale?
Yes, an investor can exchange part of the proceeds and take the rest as cash, known as boot, but the cash portion is taxable in the year received while only the exchanged portion defers.
Does the tax picture change if the rental is owned through an LLC?
A single-member LLC is disregarded for federal tax purposes, so the gain and recapture flow through to the owner's personal return exactly as they would for direct ownership. Multi-member LLCs and other entity structures have their own rules worth confirming with an accountant before the sale closes.
