The taxes you owe on the sale of an investment property is made of 2 parts:
1) Tax on the gains
Taxable Gain = Sale Price – Cost of the Sale – Adjusted Basis*.
2) Tax on total cost recovery (depreciation)
Tax on the total cost recovery taken is at the maximum of 25%.
For Example, You purchased a property for $80,000; paid 1.5% mortgage origination fee; Put a new roof for 5,000; and, kept the place for 10 years. The land is, say, 30% of the purchase price and 70% of the price is for the improvement.
If the property appreciated at, say, 2% a year, your sale price then would be $97,696 (more on time value of money in another post). It cost you a total of 6% to sell (5,862)
Taxable Gain = 97,696-5,862-65,840* = $25,994
Tax on Gain = 25,994X15% = $3,899 (capital gain tax rate ranges from 5% to 15%, please consult with your CPA).
Cost Recovery Tax** = 20,360X25% = $5,090
Total Taxes Due = 3,899+5,090 = $8,989
Sale Proceeds from Sale = Sale Price – Sales Costs – Mortgage Balance – Total Taxes Due
*Adjusted Basis = Purchase Price + Acquisition Costs + Capital Improvements – Cost Recovery Adjusted Basis = 80,000+1,200+5,000-(2,036X10) = $65,840
**Cost Recovery = (80,000X70%)/27.5 years = $2,036
Total cost recovery over 10 years is 20,360.
Note: there are other cost recoveries that are taken over different number years. For example, the cost of adding a fence is depreciated over 5 years. Please consult your CPA.