Selling a rental in Detroit or one of the surrounding suburbs triggers two separate pieces of federal tax exposure, not one: capital gains tax on the appreciation, and depreciation recapture on the deductions already claimed over the years the property was rented out. Owners who only budget for the first number are often caught off guard by the second when the CPA runs the actual return. Neither is optional to plan for once a rental goes under contract.
Calculating the Gain on a Rental Sale
The gain is sale price minus selling costs minus adjusted basis, where adjusted basis is original cost plus capital improvements minus accumulated depreciation. A three-flat purchased in Hamtramck a decade ago and depreciated every year since will have a lower basis today than the purchase price alone suggests, which pushes the taxable gain higher than a quick mental estimate. Pulling the depreciation schedule from the tax return before listing the property is the single most useful step an owner can take to get an accurate number early.
Depreciation Recapture Is Its Own Line Item
The portion of gain equal to depreciation already claimed is taxed separately as depreciation recapture, generally at a rate capped at 25 percent, regardless of the seller's regular capital gains rate. This applies even if the property barely appreciated in price, because recapture is based on deductions taken, not market gain. An owner who assumes a flat property sold for a small profit owes little tax is sometimes surprised that recapture alone produces a meaningful bill.
Federal, State, and the Net Investment Income Tax
On top of federal capital gains and recapture, Michigan taxes the gain as ordinary income at the state's flat rate, and higher-income sellers may also owe the 3.8 percent net investment income tax on top of both. Stacking all three together is what turns a gain that looked manageable on paper into a bill that changes the seller's net proceeds significantly, which is why a full tax projection before listing matters more than a rough estimate after an offer comes in.
Deferring Instead of Paying at Closing
A 1031 exchange defers both the capital gain and the recapture by rolling the proceeds into replacement investment property under IRS timing rules run through a qualified intermediary; it does not erase either tax, it carries them forward into the new property's basis. For an owner who wants to stay invested in Detroit-area real estate, whether trading a management-heavy building for a net-leased property or for a DST allocation, deferral through an exchange is worth pricing against simply paying the tax and walking away.
What to Have Ready Before Listing
A CPA-prepared basis and recapture estimate, a decision on whether an exchange is even a candidate given the ownership timeline, and a qualified intermediary lined up before closing if an exchange is the direction, since the identification clock starts the day the sale closes, not the day the owner decides to explore options. Waiting until after an accepted offer to start this process leaves very little room to change course.
Common 1031 Exchange Questions
Do I owe capital gains tax and depreciation recapture separately?
Yes, they are calculated and taxed separately, with recapture generally capped around 25 percent regardless of the seller's ordinary capital gains rate. Both are due in the year of sale unless the transaction qualifies for deferral.
Does Michigan add its own tax on top of federal capital gains?
Michigan taxes capital gains as ordinary income at the state's flat individual income tax rate, in addition to whatever is owed federally. This is separate from any recapture or net investment income tax exposure.
How far back should I pull records before selling a rental?
Back to the purchase, since the full depreciation history and every capital improvement affect the basis calculation. Missing records make it harder for a CPA to produce an accurate gain estimate before the sale closes.
Can I do a 1031 exchange on a rental I only owned for a year?
Holding period is one factor considered alongside intent to hold for investment, and shorter holds draw more scrutiny than longer ones, though there is no fixed minimum stated in the statute. This is worth confirming with a tax advisor given the specific facts.
What happens if I sell and just keep the cash instead of exchanging?
The gain and recapture become taxable in the year of sale, in full, with no deferral available after the fact. An exchange has to be set up before the relinquished property closes to be available at all.
