Sally owns a rental property that she originally purchased for $320,000 (of which the portion allocable to land is $100,000), and over the years she has taken depreciation deductions of $115,667 for this property. She is considering an offer to sell the property for $1,000,000. She estimates that the selling costs will include real estate commissions of 5 percent and other costs of 2 percent of the sales price. Sally's net gain on the sale would be $725,667, calculated as follows:

When you sell a property you've owned for more than a year, the gain (the selling price less your selling costs and your adjusted basis in the property) is taxed at capital gains rates, which are lower than the regular income tax rates. The particular capital gains rate that's used depends on several factors.

Most capital gains on sales of rental property are taxed at 15 percent but any gains due to depreciation you have already taken are taxed at 25 percent. Ordinary income, on the other hand, can be taxed with rates as high as 35 percent. Therefore, it's important to understand how much of your gain will be taxed at ordinary income tax rates and how much will be taxed at capital gains rates.

Note: The tax rates addressed here are federal taxes rates only. Any state taxes that may also be due are in addition to the federal taxes.