Ray's rental is worth $430,000 and he owes nothing on it. If he sells, $336,947 lands in his account — not $430,000. The missing $93,053 is selling costs plus a federal tax bill he has never calculated, and it is large enough that "the mortgage is paid off" turns out to be the least important fact about his decision.
Ray's Numbers
Ray is 61, single, and earns $92,000 a year from his day job. Eighteen years ago he bought a duplex for $185,000. It is worth $430,000 today, the mortgage is gone, and it rents for $2,450 a month against roughly $11,800 a year in taxes, insurance, maintenance, and vacancy.
He has been told for years that a paid-off rental is a free-and-clear asset. In cash-flow terms that is true. In sale terms it is not, because eighteen years of ownership built up something Ray has never had to think about: depreciation.
The Deduction That Becomes a Bill
Each year Ray owned the duplex, he deducted depreciation on the building — not the land. With roughly 80% of the purchase price allocated to the structure, that is $185,000 × 80% ÷ 27.5 years = $5,382 a year. Over eighteen years: $96,873.
That $96,873 lowered his taxable rental income every year he owned it. It also lowered his cost basis by exactly the same amount, and at sale the IRS takes it back as "unrecaptured Section 1250 gain," taxed at a rate capped at 25%.
The critical wrinkle: this applies whether or not Ray actually claimed the deductions. The rule is "allowed or allowable." A landlord who never filed depreciation still owes the recapture — the only thing skipping it accomplishes is losing the deduction while keeping the bill. (This trap is worth understanding on its own; we covered it in the depreciation mistake that costs landlords thousands.)
The Full Sale Math
Running Ray's numbers through the same logic the calculator uses:
| Line | Amount |
|---|---|
| Sale price | $430,000 |
| Selling costs (7% — commissions, title, transfer) | −$30,100 |
| Adjusted basis ($185,000 − $96,873 depreciation) | −$88,127 |
| Total taxable gain | $311,773 |
That gain then splits into two pieces taxed at two different rates:
| Tax | Base | Rate | Amount |
|---|---|---|---|
| Depreciation recapture | $96,873 | graduated, capped at 25% | $22,975 |
| Long-term capital gains | $214,900 | 15% | $32,235 |
| Net Investment Income Tax | $203,773 | 3.8% | $7,743 |
| Total federal tax | $62,953 |
The recapture line isn't a flat 25% — that rate is a ceiling, not the rate everyone pays. The $96,873 of recapture stacks on top of Ray's $92,000 of ordinary income and runs through the regular graduated brackets; only the slice that would land above the top of the 24% bracket gets charged the full 25%. For Ray, none of it reaches that high, so his effective recapture rate works out closer to 23.7% than 25%.
His 15% capital gains rate comes from where the gain lands: $92,000 of ordinary income plus $214,900 of gain puts him well past the $49,450 top of the 0% bracket for single filers, and nowhere near the $545,500 where 20% starts.
The NIIT line is the one that surprises people. That 3.8% surtax applies once modified AGI passes $200,000 for single filers — and Ray, whose normal income is $92,000, blows through it in the single year he sells. The threshold has not been adjusted for inflation since it was written, so it captures more one-time sellers every year.
Cash to Ray: $430,000 − $30,100 − $62,953 = $336,947. Selling converts his $430,000 asset into $336,947 of investable money. The haircut — about 21.6% of the sale price — happens before he makes a single decision about what to do next.
What Keeping Actually Earns
The other half of the decision is what the property produces if he does nothing:
- Cash flow: ($2,450 × 12) − $11,800 = $17,600
- Appreciation at 3%: $430,000 × 3% = $12,900
- Principal paydown: $0 — the loan is gone
Total annual wealth building: $30,500 on $430,000 of equity, or a 7.1% return on equity.
Now compare that to the alternative. If Ray sells and invests the $336,947 at a 7% long-run return, he earns about $23,586 a year. Keeping the duplex produces $30,500. Selling to reinvest costs him roughly $6,900 a year in return — and that is after he has already surrendered $93,053 to get out.
Why "It's Paid Off" Points the Wrong Way
Paying off the mortgage feels like the finish line, and it changes the emotional math completely: no payment, no lender, no risk of a bad month. But it changes the investment math in an uncomfortable direction. Ray now has $430,000 of equity sitting in one asset earning 7.1%. When he had a mortgage, the same building was producing a similar dollar return on a much smaller slice of his own money.
That is the real question in front of him, and it is not "should I sell?" It is: is 7.1% on $430,000 the best use of $430,000 — knowing that moving it costs $93,053 in transaction friction and tax?
For Ray the answer leans toward keeping, mostly because the exit cost is so high. But the calculation flips fast if any of three things change: the building starts eating capital (a roof, a sewer line, a bad tenant cycle), the rent stops keeping up with expenses, or he needs the money for something the property cannot fund.
The Options That Change the Answer
A 1031 exchange defers the entire $62,953 — recapture and capital gains both — if he rolls the proceeds into another investment property. The rules are unforgiving: a Qualified Intermediary must hold the funds, replacements identified within 45 days, closing within 180. This is the right tool when the problem is this building, not real estate itself.
Holding until death erases it. Heirs inherit at stepped-up basis, and the deferred gain and the recapture disappear entirely. At 61, this is a real planning variable rather than a morbid footnote, and it deserves a conversation with an estate attorney before he lists.
Moving in for two years helps less than most people expect. The Section 121 exclusion is prorated between qualified and non-qualified use, so eighteen rental years mean most of the gain stays taxable — and recapture survives the move-in entirely.
One caveat on all of the above: every number here is federal only. State capital gains tax runs from 0% to over 13% depending on where the property sits, and in a high-tax state it can add five figures to the $62,953.
Frequently Asked Questions
Does a paid-off rental change how much tax I owe when I sell?
No. The mortgage balance affects how much cash you walk away with, not the tax. Tax is calculated on sale price minus selling costs minus adjusted basis — the loan never enters the formula. Ray owes the same $62,953 whether the duplex is paid off or carries a $200,000 mortgage; the mortgage only changes what is left after the tax is paid.
What if I never claimed depreciation on my rental?
You still owe the recapture. The IRS applies the "allowed or allowable" standard, meaning it calculates recapture on the depreciation you could have claimed. Skipping the deduction loses you the annual tax benefit and keeps the bill at sale — the worst of both. If this describes you, ask a CPA about Form 3115 to correct the accounting method before you sell.
Why does the 3.8% NIIT apply if my income is only $92,000?
Because the gain itself counts toward the threshold in the year of the sale. Ray's modified AGI in the sale year is $92,000 plus $311,773 of gain, which lands far above the $200,000 single-filer line. The surtax applies to the lesser of the gain or the amount over the threshold — $203,773 in his case. Spreading a sale via an installment sale is one way to manage this, and is worth pricing with a CPA.
Is a 7.1% return on equity good or bad for a rental?
It is unremarkable, which is exactly why it needs comparing. A leveraged rental often shows a higher return on equity because a smaller amount of your own money controls the asset. Once a property is paid off, the return converges toward the underlying performance of the building itself. The number is only "bad" if you have somewhere better to put $430,000 — after paying the exit cost to move it.
How accurate is the depreciation estimate in this article?
It is a straight-line estimate from purchase price and an assumed 80% building allocation. Your actual figure comes from Form 4562 and the depreciation schedules on your past returns, and it can differ meaningfully if you did a cost segregation study, claimed bonus depreciation on improvements, or placed the property in service mid-year. Pull the real number before making a decision this size.
Run Your Own Numbers
Ray's answer is not your answer — it turns on his purchase price, his eighteen years of depreciation, his $92,000 income, and his single-filer brackets. Change any one of those and the tax bill moves by tens of thousands.
The Sell vs Keep Rental Calculator runs both sides of this decision on your own figures: what you would actually pocket after selling costs, recapture, capital gains, and NIIT — and what keeping the property earns on the equity you already have in it.