Capital Gains Tax on Commercial Property: Rates and Deferral Options

When you sell commercial property, federal capital gains tax on commercial property applies to the difference between your net sale proceeds and your adjusted basis, and that gain gets split into two pieces taxed at different rates. The depreciation you took (or were entitled to take) is recaptured at a federal rate of up to 25%. The rest, representing genuine appreciation, is taxed at long-term capital gains rates of 0%, 15%, or 20% if you held the property more than a year. A 3.8% net investment income tax can sit on top of both layers, and state tax comes after that. For many sellers, the combined bite lands above 25% of the profit.

How the Gain Is Calculated

The formula is simple. Amount realized minus adjusted basis equals your taxable gain. What makes commercial property different from most other assets is what the IRS forces you to do to that basis before the subtraction.

Amount Realized

The amount realized is everything of value you receive from the buyer — cash, debt they assume, and the fair market value of any other property — reduced by the direct costs of the sale. Broker commissions, legal fees, title insurance, and transfer taxes all come off the top.

Adjusted Basis, and Why It’s Lower Than You Think

Your basis starts with what you paid for the property, plus acquisition costs like title fees, surveys, appraisals, recording fees, and purchase-related legal fees. If you inherited the property, your starting basis is the fair market value on the date of the prior owner’s death.

Two adjustments then move the number in opposite directions.

Capital improvements increase basis. A roof replacement, a new HVAC system, structural additions, and ADA-compliance renovations all qualify. Routine repairs and maintenance do not.

Depreciation decreases basis, and this is where most owners underestimate their tax bill. Commercial buildings are Section 1250 property, depreciated straight-line over 39 years.1Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty2Internal Revenue Service. Publication 946, How To Depreciate Property Only the building depreciates; land does not, so you split the purchase price between them at the time of purchase, usually by relative fair market value or by local assessed values.3Internal Revenue Service. Publication 551, Basis of Assets

Here’s the trap. The statute reduces your basis by depreciation that was “allowed or allowable,” meaning the IRS treats you as though you took every deduction you were entitled to, whether you actually claimed it or not.4Office of the Law Revision Counsel. 26 US Code 1016 – Adjustments to Basis Skipping depreciation to save tax later doesn’t work. The basis still drops.

A $1 million building depreciated for 15 years accumulates roughly $385,000 in depreciation (about $25,641 per year), leaving the building’s basis near $615,000. Add the undepreciated land back in, and the total adjusted basis is often much lower than owners assume.

How the Gain Is Taxed

Once you have a gain figure, federal law splits it and applies different rates to each piece.

Holding Period

Held one year or less, the entire gain is short-term and taxed as ordinary income at your marginal rate, which reaches 37% for 2026.5Internal Revenue Service. Topic No. 409, Capital Gains and Losses6Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026 Held more than a year, the gain qualifies for long-term treatment.

The Two-Layer Split on Long-Term Gains

Long-term gain on commercial property is not taxed at a single rate. The IRS pulls out the portion attributable to depreciation you took or should have taken and calls it “unrecaptured Section 1250 gain.” That layer faces a maximum federal rate of 25%.1Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty It gets taxed first.

What remains is the appreciation piece. That portion runs through the regular long-term capital gains brackets: 0%, 15%, or 20%, depending on your total taxable income. For 2026, the 20% rate begins above $545,500 for single filers and $613,700 for married couples filing jointly.7Internal Revenue Service. Revenue Procedure 2025-32 A commercial property sale often pushes the seller into the 20% bracket on its own, because the gain stacks on top of ordinary income for the year.

The 3.8% Net Investment Income Tax

A separate 3.8% surtax applies when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax It hits the lesser of your net investment income or the amount by which your income clears the threshold. Those thresholds have not been adjusted for inflation since the tax took effect in 2013, so they catch more sellers every year.

Stack everything and the maximum federal rate on the depreciation portion is 28.8% (25% plus 3.8%), and the maximum on the appreciation portion is 23.8% (20% plus 3.8%). State income tax adds another layer; some states tax capital gains at full ordinary rates, and a handful impose no income tax at all.

A Worked Example

You bought a commercial building 10 years ago for $1,000,000, allocating $200,000 to land and $800,000 to the building. Straight-line depreciation over 10 years totals about $205,000. You spent $50,000 on a new roof, which added to basis. Your adjusted basis is $1,000,000 plus $50,000 minus $205,000, or $845,000.

You sell for $1,600,000 and pay $80,000 in commissions and closing costs. Amount realized: $1,520,000. Gain: $675,000. Of that, $205,000 is depreciation recapture taxed at up to 25%, and the remaining $470,000 is taxed at your long-term capital gains rate. If your income is high enough, 3.8% NIIT sits on top of both.

Ways to Reduce, Defer, or Eliminate the Bill

1031 Like-Kind Exchange

The most common deferral tool. You roll the proceeds into another investment or business-use property and defer the entire gain until you sell the replacement.9Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment Personal residences and property held for resale don’t qualify.

Nearly every 1031 today is a deferred exchange using a qualified intermediary who holds the sale proceeds. If you take constructive receipt of the cash — even briefly — the exchange fails and the whole gain becomes taxable.10Internal Revenue Service. Revenue Procedure 2003-39

Two deadlines run from the day you close on the sale: 45 days to identify replacement properties in writing, and 180 days to close on one.9Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment The 180 days include the 45. Miss either and the deferral is gone.

To defer the entire gain, the replacement property must be equal or greater in value, and all proceeds must be reinvested. Leftover cash or reduced mortgage debt from old to new is “boot” and is taxable up to the amount of the gain. Debt relief is the most commonly missed form of boot: a $500,000 mortgage traded for a $350,000 mortgage produces $150,000 of boot unless you add cash to close the gap.

Installment Sale

If a 1031 doesn’t fit, seller financing lets you spread the gain over the years you receive payment.11Office of the Law Revision Counsel. 26 US Code 453 – Installment Method Each payment carries its proportional share of gain. The main planning advantage is keeping annual income below the thresholds that trigger the 20% capital gains rate or the 3.8% NIIT.

One catch: the IRS charges interest on the deferred tax when the sale price exceeds $150,000 and total outstanding installment obligations exceed $5 million at year end.12Internal Revenue Service. Interest on Deferred Tax Liability On large commercial sales, that interest can erode much of the benefit.

Suspended Passive Activity Losses

Rental losses you couldn’t deduct in earlier years because of the passive activity rules don’t disappear. When you sell your entire interest in the property in a fully taxable transaction, those suspended losses become fully deductible in the year of sale.13Internal Revenue Service. Topic No. 425, Passive Activities – Losses and Credits They offset the gain dollar for dollar. Owners often forget this benefit is sitting on their prior returns.

Step-Up in Basis at Death

Property passing through an estate receives a basis equal to its fair market value at the date of death.14Office of the Law Revision Counsel. 26 US Code 1014 – Basis of Property Acquired From a Decedent Accumulated depreciation and unrealized appreciation are effectively wiped. A property with a $500,000 adjusted basis and $2 million fair market value at death passes to heirs at a $2 million basis; a next-day sale would generate almost no capital gains tax. For older investors, holding through death is a legitimate strategy where non-tax priorities allow.

Qualified Opportunity Zones

Capital gains reinvested into a Qualified Opportunity Fund defer immediate tax, and appreciation on the fund investment is permanently excluded from income if the investment is held at least 10 years.15Internal Revenue Service. Opportunity Zones Frequently Asked Questions The original program required deferred gains to be recognized by December 31, 2026. New legislation has overhauled the program for investments made after that date, with a rolling five-year deferral, a 10% basis step-up for standard zones (30% for rural), a 30-year cap on gain exclusion, and new zone designations effective January 1, 2027. Because the rules are transitioning, the specific benefits depend on when you invest.

Forms You’ll File

Most commercial sales involve at least two forms, and more if you use a deferral strategy.

The depreciation recapture calculation alone justifies working with a preparer who has done commercial sales before. Errors in the basis adjustment or the split between recapture and appreciation can trigger IRS adjustments years after filing, and the amounts at stake usually dwarf the cost of getting the return right the first time.