Capital Gains Tax on Rental Property

The taxable gain on a rental property is the sale price minus the adjusted basis, and adjusted basis is not simply the original purchase price. It is purchase price plus capital improvements, minus accumulated depreciation claimed over the holding period. A landlord who bought a duplex near Colorado State University in Fort Collins a decade ago and depreciated it every year since has a lower basis, and therefore a larger taxable gain, than the purchase price alone would imply.

Long-term federal capital gains rates of 0%, 15%, or 20% apply to property held over a year, with the 3.8% net investment income tax layered on for higher earners. Colorado's flat 4.4% state income tax then applies to the same gain, with no separate lower rate carved out for real estate.

Every year a rental is depreciated, the IRS effectively defers a piece of tax that comes due at sale. That recaptured depreciation is taxed at a maximum federal rate of 25% (known as unrecaptured Section 1250 gain), which is often higher than the long-term capital gains rate applying to the rest of the appreciation. A Denver metro landlord who has owned and depreciated a fourplex for 15 years may find that recapture accounts for a larger share of the total tax bill than the appreciation itself.

The math plays out differently depending on submarket. Long-held single-family rentals near CU Boulder or CSU Fort Collins tend to carry heavy depreciation relative to purchase price because they were bought decades ago at much lower values. Newer Denver metro or Colorado Springs multifamily purchases carry less accumulated depreciation but often more appreciation, since Front Range values have moved substantially in the last several years. A short-term rental in a mountain town like Breckenridge or Steamboat Springs adds a further wrinkle, since personal-use days can affect whether the property even qualifies as investment property for exchange purposes.

A Section 1031 exchange lets a landlord roll both the appreciation and the recaptured depreciation into a replacement investment property, deferring the entire combined tax bill rather than paying it in the sale year. The replacement does not have to be another rental of the same type; a Front Range single-family rental can exchange into a multifamily building, a net-lease retail property, or a DST placement, as long as both properties are held for investment or business use.

The tradeoff is the 45-day identification and 180-day closing deadlines, plus the requirement that the qualified intermediary hold proceeds so the seller never has direct control of the funds. Skipping either step disqualifies the exchange and the tax comes due as if no deferral had been attempted.

Before listing a Colorado rental, a landlord should pull the depreciation schedule from their tax preparer, estimate the recapture separately from the appreciation gain, and decide whether a 1031 exchange, an installment sale, or simply paying the tax makes more sense given their timeline and reinvestment plans. That estimate should come from a CPA working from the actual depreciation records, not a rough guess based on sale price alone.