A Real Estate Investor’s Guide to Understanding Tax Exposure
When it comes to investment real estate, a useful financial lever is equity—the portion of a property’s value you own outright. As property values rise and debt is paid down, equity builds.
When an investor chooses to sell a property and convert equity into cash, capital gains tax may apply. This tax is based not on the amount of equity, but on the realized gain above the property's adjusted basis.
Understanding how this tax applies to equity is important for making informed decisions, preserving wealth, and minimizing avoidable tax exposure.
Equity vs. Capital Gains: What’s the Difference?
Before diving into tax treatment, it’s important to clarify the difference between equity and capital gain.
Equity is the difference between a property’s market value and any outstanding mortgage or debt. Capital gain, on the other hand, is the profit realized when the property is sold for more than its adjusted basis—typically calculated as the purchase price, plus improvements, minus depreciation.
You don’t owe capital gains tax just because you have equity. The tax is triggered only when you sell the property and realize a gain.
How Capital Gains Are Calculated
Here’s a simplified formula:
Capital Gain = Sale Price - Adjusted Basis - Selling Costs
Suppose you purchased a property for $500,000, made $50,000 in improvements, and claimed $100,000 in depreciation. Your adjusted basis would be $450,000. If you sell the property for $800,000, your gain would be:
$800,000 – $450,000 = $350,000 capital gain
This gain—not the total equity—is subject to capital gains tax.
Short-Term vs. Long-Term Gains
How long you’ve held the property significantly affects the tax rate.
If the property has been held for more than one year, the gain is treated as a long-term capital gain. These gains are typically taxed at 0%, 15%, or 20%, depending on your income bracket.
If the property is held for one year or less, the gain is classified as short-term and taxed at ordinary income tax rates—which can be significantly higher.
Don’t Forget Depreciation Recapture
Depreciation claimed during the life of the property is “recaptured” upon sale and taxed at a maximum 25% rate but only to the extent that the total gain on the sale is equal to or greater than the depreciation taken. In the example above, that $100,000 of depreciation would not be taxed at capital gains rates but at the recapture rate.
Offsetting Gains with Losses
If you sell another investment at a loss in the same year, you may be able to use that capital loss to offset your gains. The IRS allows you to offset dollar-for-dollar gains with losses and even deduct up to $3,000 of net capital loss against ordinary income annually (with the rest carried forward).
Consider a 1031 Exchange
Suppose your goal is to defer taxes while continuing to invest in real estate. In that case, a 1031 Exchange may allow you to reinvest the proceeds from a property sale into another like-kind property, deferring capital gains taxes. When structured properly, this strategy enables tax deferral on recognized gains and can support ongoing portfolio realignment and real estate exposure.
Final Thoughts
Capital gains tax doesn’t apply to equity itself—it applies to the gain realized when equity is unlocked through a sale. For real estate investors, understanding this distinction and planning for the tax consequences can be a key part of long-term wealth management.
Consulting a qualified tax professional is always recommended to tailor these principles to your investment situation.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
