The case for a 1031 exchange starts with the cost of not doing one. Selling appreciated investment property can trigger four layers of tax — federal capital gains, depreciation recapture, the net investment income tax, and state tax — and most investors underestimate the total because they think only of the headline capital gains rate. This guide lays out each rate, how the layers stack, how to calculate your effective rate, and how a 1031 exchange defers the whole thing.
What You'd Pay Without a 1031
An outright sale of appreciated investment property can trigger four separate taxes. The headline is the federal long-term capital gains rate, but layered on top are depreciation recapture, the 3.8% net investment income tax, and state capital gains tax. Together they determine what you'd surrender by selling rather than exchanging.
Understanding these rates is the foundation for deciding whether a 1031 exchange is worth it. The bigger your combined rate and your gain, the more an exchange defers — and the more compelling the strategy.
The sections below cover each rate in turn, then show how they stack into an effective rate and how a 1031 changes the calculation.
Long-Term vs. Short-Term Rates
How long you held the property matters enormously. Property held more than a year qualifies for long-term capital gains rates (0%, 15%, or 20%), which are favorable. Property held a year or less is taxed at short-term rates — your ordinary income rate, which can reach 37% federally.
Most 1031 exchanges involve long-held investment property, so the long-term rates apply. But the distinction matters for newer acquisitions, and it underscores why holding period is part of the tax picture.
Property held primarily for sale (dealer inventory or flips) is treated differently still — taxed as ordinary income and ineligible for 1031 — which we cover below.
The 0/15/20 Capital Gains Brackets
Long-term capital gains are taxed at 0%, 15%, or 20% based on your taxable income. Lower-income taxpayers may qualify for the 0% or 15% rate; higher-income taxpayers reach the 20% rate. The thresholds adjust periodically, so check the current brackets for your filing status.
This rate applies to the appreciation portion of your gain — your sale price minus your adjusted basis, excluding the depreciation-recapture portion. For most investment-property sellers with significant gains, the 15% or 20% rate applies.
A large gain can also push you into a higher bracket and over the NIIT threshold, so the rate that applies depends on your total income for the year, not just the gain in isolation.
The Depreciation Recapture Rate (Up to 25%)
The portion of your gain attributable to depreciation you took — unrecaptured Section 1250 gain — is taxed at a maximum of 25%, higher than the long-term capital gains rate. This is the layer that surprises long-term landlords, because years of depreciation deductions create a large recapture amount on sale.
Recapture exists to recover part of the benefit you received from depreciation deductions during ownership. The more you depreciated, the larger the recapture, and on a property held for decades it can be the single biggest tax component.
Because recapture is rated higher than capital gains, it's also recognized first when partial gain is triggered (for example by boot in an exchange) — making even small amounts of recognized gain costlier than you might expect.
The 3.8% NIIT Surtax
The net investment income tax adds 3.8% on capital gains for higher-income taxpayers whose modified adjusted gross income exceeds certain thresholds. It stacks on top of the capital gains and recapture rates, increasing the effective rate on the gain.
A large property gain can push your income over the NIIT threshold even if your ordinary income wouldn't, so the surtax catches many one-time sellers off guard. On a $500,000 gain, it's $19,000.
A 1031 exchange defers the NIIT along with the other layers, since no gain is recognized at the exchange to trigger it.
State Capital Gains Rates
State tax is the most variable layer. No-income-tax states (Texas, Florida, Nevada, Washington, and others) impose no state capital gains tax. High-tax states like California tax gains as ordinary income at top rates exceeding 13%; many states fall somewhere in between at 3–7%.
For high-income sellers in high-tax states, the state layer can rival or exceed the federal capital gains tax, making it the largest single piece of the bill. Some states also impose withholding on sales by nonresidents or have clawback rules affecting deferred gain.
Because state tax varies so widely, your location is one of the biggest factors in your total rate — and in how much a 1031 exchange saves you.
- Long-term gains: 0/15/20%; recapture: up to 25%; NIIT: 3.8%; state: 0% to 13%+.
- Recapture often makes long-held rentals costly to sell and is taxed first.
- A 1031 defers all four layers, preserving your full equity.
How the Layers Stack
The four layers apply to different parts of your gain but combine into one bill. Recapture (up to 25%) applies to the depreciated portion; long-term capital gains (15–20%) apply to the appreciation; the NIIT (3.8%) and state tax apply, for those subject to them, to the relevant gain.
To see your total, calculate each layer on its applicable base and add them. A heavily depreciated property in a high-tax state stacks all four near their maximums; a modestly appreciated property in a no-tax state for a lower-income seller might face only the 15% federal rate.
This stacking is why the effective rate on a gain ranges so widely — from the mid-teens to over 35% — and why estimating your specific situation, rather than assuming a single rate, matters.
Calculating Your Effective Rate
Your effective rate is the total tax divided by your total gain. To find it, compute recapture (25% × depreciation taken), capital gains (15% or 20% × appreciation), NIIT (3.8% × gain, if applicable), and state tax (state rate × gain), then divide the sum by your total gain.
For the California example earlier — $500,000 gain, $150,000 recapture — the total was about $191,500, an effective rate near 38%. For a no-tax-state, lower-income seller, the effective rate might be 17% or less.
Knowing your effective rate tells you exactly what a sale costs and what a 1031 exchange defers, which is the number that should drive the decision.
How Adjusted Basis Affects the Gain
Your gain — and therefore your tax — depends on your adjusted basis: your original cost, plus capital improvements, minus depreciation taken. The lower your basis, the larger your gain, and depreciation is the main reason a long-held property's basis (and thus its tax) is so significant.
Improvements you've made increase basis and reduce gain, so keeping good records of capital improvements over the years can meaningfully lower your tax. Depreciation does the opposite — it lowers basis and increases both gain and the recapture layer.
Because basis drives the whole calculation, accurate basis tracking is essential, and it's one reason a CPA's records matter so much — especially across multiple exchanges where basis carries over.
How a 1031 Changes the Math
A 1031 exchange defers every one of these layers. Instead of paying a third or more of your gain in tax and reinvesting what's left, you reinvest the full amount into like-kind property, carrying your basis (and the deferred gain) forward.
This is why the exchange is so valuable for high-basis-depreciation, high-tax-state sellers in particular — they face the steepest combined rate, so they have the most to defer. The deferred tax then keeps compounding in the replacement property.
The choice, in effect, is between surrendering a large slice of your gain to four taxes now or keeping it all invested and potentially never paying it (if you hold until a step-up at death). For many investors, the rates make that an easy call.
Rates by State: A Few Examples
To make the state layer concrete: a seller in Texas, Florida, Nevada, or Washington pays no state capital gains tax, facing only the federal layers. A seller in a moderate-tax state like Georgia or Virginia might pay around 5–6% state tax on the gain.
A seller in a high-tax state like California can pay over 13% at the top, and in New York or New Jersey, high single digits to low double digits. These differences can swing the total tax by tens of thousands of dollars on a large gain.
Because the property's location (and sometimes your residency) determines the state layer, where you sell matters as much as what you sell. Confirm your specific state's treatment — and any withholding or clawback rules — with your CPA.
Short-Term and Dealer Property
Not all real estate gets capital gains treatment. Property held a year or less is taxed at short-term rates — your ordinary income rate, up to 37% federally — which is much higher than the long-term rate. And property held primarily for sale (dealer inventory, flips) is taxed as ordinary income regardless of holding period.
Dealer property is also ineligible for a 1031 exchange, because it isn't held for investment. This is why intent and holding pattern matter: a flipper's inventory doesn't qualify, while an investor's rental does.
If you're unsure whether your property is investment or dealer property — for example, if you've subdivided and sold lots — that's a question for your CPA, because it determines both your tax rate and your 1031 eligibility.
Planning Around the Rates
Understanding the rates opens planning opportunities. Holding property more than a year secures the favorable long-term rates. Timing a sale in a lower-income year can reduce the capital gains bracket and avoid the NIIT. Keeping good records of capital improvements increases basis and reduces gain.
But the most powerful planning tool for the four-layer tax is the 1031 exchange itself, which defers all of it. For investors who want to stay in real estate, deferring through an exchange almost always beats paying the stacked rate now.
Coordinate the timing and structure with your CPA, who can model your specific rates and confirm whether an exchange, an installment sale, or another approach best fits your situation.
Worked Examples of the Combined Rate
Seeing the rates applied makes them concrete. Example 1 — high-income California seller: a $500,000 gain with $150,000 of recapture faces 20% federal capital gains on $350,000 ($70,000), 25% recapture on $150,000 ($37,500), 3.8% NIIT on $500,000 ($19,000), and ~13% California tax on $500,000 ($65,000) — about $191,500, an effective rate near 38%.
Example 2 — moderate-income Georgia seller: a $300,000 gain with $80,000 of recapture faces 15% on $220,000 of appreciation ($33,000), 25% on $80,000 of recapture ($20,000), no NIIT (income below the threshold), and ~5.75% Georgia tax on $300,000 (~$17,250) — about $70,250, an effective rate near 23%.
Example 3 — Texas seller, lower bracket: a $200,000 gain with $40,000 of recapture faces 15% on $160,000 ($24,000), 25% on $40,000 ($10,000), no NIIT, and no state tax — $34,000, an effective rate of 17%.
The three examples span 17% to 38% effective rates on the same kind of transaction, driven by income, depreciation, and state. Each of those amounts is exactly what a 1031 exchange would defer. Figures are illustrative and depend on current rates and your specifics, but they show how widely the combined rate ranges and why estimating your own is essential.
State Withholding and Clawback Rules
Beyond the headline state rate, two state-level wrinkles can affect your sale. Many states impose withholding on real estate sales by nonresidents — the closing agent withholds a percentage of the sale price or gain and remits it to the state, which you reconcile when you file. This affects cash flow even when a 1031 exchange ultimately defers the tax, though properly documented exchanges are often exempt from withholding.
Some states also have clawback rules. California, for example, tracks deferred gain on California property exchanged into out-of-state replacement property; when that gain is eventually recognized, California claims its share even if you've since moved away. The deferral still works, but the state doesn't forget the gain that originated within its borders.
These rules don't change the federal analysis, but they affect the state layer and your closing logistics. If you're exchanging across state lines or selling as a nonresident, confirm the withholding and clawback rules with your CPA in advance, and make sure your qualified intermediary documents the exchange properly to claim any available withholding exemption.
The practical takeaway is that state tax is more than a single rate — it can involve withholding at closing and long-tail clawback obligations. For high-tax-state sellers, these are worth understanding before you sell, because they shape both the timing and the ultimate amount of the state layer that a 1031 exchange defers.
The Bottom Line on the Rates
The rates on an investment-property sale stack into a number most investors underestimate: long-term capital gains at 0/15/20%, recapture at up to 25%, the 3.8% NIIT, and state tax from 0% to over 13%. For a long-held, heavily depreciated property in a high-tax state, the combined effective rate can exceed 35%.
That number is exactly what a 1031 exchange defers. Knowing your rates — and therefore what a sale would cost — is the foundation for deciding whether to exchange, and it usually makes the case for deferral compelling.
Run your own figures with your CPA or a calculator, because the right answer depends on your gain, your depreciation, your income, and your state. But for most investors with meaningful gain, the rates alone justify a serious look at a 1031 exchange.
Frequently Asked Questions
What are the capital gains tax rates on investment property?
Long-term gains (property held over a year) are taxed at 0%, 15%, or 20% by income; depreciation recapture is taxed up to 25%; a 3.8% NIIT surtax applies to higher earners; and state rates range from 0% to over 13%. A 1031 exchange defers all of them.
What's the difference between long-term and short-term rates?
Long-term rates (0/15/20%) apply to property held more than a year and are favorable. Short-term rates apply to property held a year or less and equal your ordinary income rate, up to 37% federally. Most 1031 exchanges involve long-held property at long-term rates.
Why is depreciation recapture taxed higher?
Recapture (unrecaptured Section 1250 gain) is taxed at up to 25%, above the long-term capital gains rate, to recover part of the benefit of the depreciation deductions taken during ownership. On long-held rentals it's often the largest single tax layer.
Does the 3.8% NIIT apply to property sales?
It can. Higher-income taxpayers owe an additional 3.8% net investment income tax on capital gains when modified AGI exceeds certain thresholds, which a large property gain can push you over. A 1031 defers it along with the other layers.
How do state capital gains rates vary?
From 0% in no-income-tax states (Texas, Florida, Nevada, Washington) to over 13% in California, with many states at 3–7% in between. For high-income sellers in high-tax states, the state layer can be the largest single piece of the tax.
How do I calculate my effective tax rate on a sale?
Compute recapture (25% × depreciation taken), capital gains (15–20% × appreciation), NIIT (3.8% × gain if applicable), and state tax (state rate × gain), add them, and divide by your total gain. The result ranges from the mid-teens to over 35% depending on your situation.
How does a 1031 change my tax bill?
It defers all four layers — capital gains, recapture, NIIT, and state tax — so instead of paying tax now you reinvest the full gain into like-kind property. Your basis carries forward and the deferred tax keeps compounding in the replacement property.
How does my adjusted basis affect my tax?
Your gain equals sale price minus adjusted basis (cost plus improvements minus depreciation). A lower basis means a larger gain and more tax. Capital improvements raise basis and reduce gain, while depreciation lowers basis and increases both gain and the recapture layer.
Is flipped or dealer property taxed differently?
Yes. Property held primarily for sale (flips, dealer inventory) is taxed as ordinary income regardless of holding period and is ineligible for a 1031 exchange because it isn't held for investment. Investment property held over a year gets long-term capital gains treatment.
What's the highest combined rate I could pay?
For a high-income seller of a heavily depreciated property in a high-tax state, the combined effective rate can exceed 35% — 20% federal capital gains, 25% recapture on the depreciated portion, 3.8% NIIT, and state tax over 13%. A 1031 defers all of it.
Does where I sell affect my tax?
Yes — the property's location (and sometimes your residency) determines the state layer, which ranges from 0% to over 13%. Selling the same gain in California versus Texas can differ by tens of thousands of dollars in state tax. Confirm your state's rules, including any withholding or clawback, with your CPA.
Can I reduce my capital gains rate by timing the sale?
Sometimes. Selling in a lower-income year can keep you in a lower capital gains bracket and below the NIIT threshold. Holding more than a year secures long-term rates. But the most powerful tool for the four-layer tax is a 1031 exchange, which defers all of it.
Does a 1031 eliminate these taxes?
No — it defers them during your lifetime. The deferred layers come due if you sell the replacement property without exchanging again. They can be eliminated only through a step-up in basis at death, which is the basis of the swap-till-you-drop strategy.
How do improvements affect my capital gains?
Capital improvements increase your adjusted basis, which reduces your taxable gain and therefore your capital gains tax. Keeping good records of improvements over the years can meaningfully lower the tax on an eventual sale.
Where can I estimate my capital gains tax?
Baker 1031 offers capital-gains and 1031 calculators at baker1031.com/calculators that estimate your tax from your sale price, basis, depreciation, state, and income. Treat the result as a planning estimate and confirm the exact figures with your CPA.
Does my state withhold tax when I sell?
Many states withhold a percentage of the sale price or gain on real estate sold by nonresidents, remitted to the state and reconciled when you file. Properly documented 1031 exchanges are often exempt from withholding, but confirm your state's rules and ensure your qualified intermediary documents the exchange to claim any exemption.
What is a state clawback rule?
Some states, like California, track deferred gain on in-state property exchanged into out-of-state replacement property and claim their share when that gain is eventually recognized — even if you've since moved away. The deferral still works, but the state doesn't forget gain that originated within its borders. Confirm clawback rules with your CPA if exchanging across state lines.
Are these capital gains rates the same every year?
The structure (0/15/20% long-term, 25% recapture maximum, 3.8% NIIT, plus state) has been stable, but the income thresholds for the brackets and the NIIT adjust periodically, and state rates can change. Check the current-year figures for your filing status, or use a calculator and your CPA, when estimating your specific tax.
How much does selling in California cost versus Texas?
The federal layers (capital gains, recapture, NIIT) are the same, but California adds over 13% state tax at the top while Texas adds none. On a $500,000 gain, that state difference alone can be roughly $65,000. Where you sell can swing the total tax by tens of thousands of dollars — all of which a 1031 defers.
Do improvements lower my capital gains tax?
Yes. Capital improvements increase your adjusted basis, which reduces your taxable gain and therefore your capital gains tax. Keeping records of improvements over the years of ownership can meaningfully lower the tax on an eventual sale or the gain carried into an exchange.
Glossary
- Long-Term Capital Gains
- Gains on property held over a year, taxed federally at 0%, 15%, or 20% by income.
- Short-Term Capital Gains
- Gains on property held a year or less, taxed at ordinary income rates up to 37%.
- Unrecaptured Section 1250 Gain
- Depreciation-related gain on real estate, taxed at a maximum of 25%.
- Depreciation Recapture
- Tax on the portion of gain attributable to prior depreciation, up to 25%.
- Net Investment Income Tax (NIIT)
- A 3.8% surtax on net investment income for higher-income taxpayers.
- State Capital Gains Tax
- State-level tax on gains, from 0% to over 13%.
- Effective Tax Rate
- Total tax divided by total gain — the combined rate of all applicable layers.
- Adjusted Basis
- Original cost plus improvements minus depreciation; subtracted from sale price to find gain.
- Dealer Property
- Real estate held primarily for sale; taxed as ordinary income and ineligible for 1031.
- Capital Improvement
- A cost that adds to basis, reducing taxable gain on sale.
- Modified AGI
- Adjusted gross income with certain add-backs, used to determine NIIT applicability.
- Holding Period
- How long you owned the property, determining long-term vs. short-term treatment.
- Carryover Basis
- The relinquished basis carried into the replacement property in a 1031 exchange.
Sources & References
- IRS. Capital gains and like-kind exchanges
- IPX1031. Capital gains and recapture in 1031
- Baker 1031 Investments. 1031 & DST Calculators
- JTC Group. 1031 and Real Estate: Answers to Common Questions
Disclosures
This article is published by Baker 1031 Investments, LLC for general educational purposes for accredited investors and is not an offer to sell or a solicitation of an offer to buy any security, nor is it tax, legal, accounting, or investment advice or a recommendation. Any securities offering is made solely through a sponsor’s private placement memorandum (PPM) following a suitability determination. Securities offered through Aurora Securities, Inc. (ASI), member FINRA / SIPC; Baker 1031 Investments is independent of ASI.
Oil & gas mineral and royalty interests and DST programs are speculative, illiquid securities sold only to verified accredited investors and involve substantial risk, including possible loss of principal, commodity-price and production-decline risk, lack of control, and the risk that an intended 1031 exchange fails to qualify for tax deferral. Whether a particular interest qualifies as like-kind real property is a fact-specific legal determination that varies by state and by the terms of the instrument. Tax results depend on your individual circumstances. Consult your own CPA and attorney before acting. Past performance does not guarantee future results.
