Key Takeaways
- Net proceeds waterfall: gross price minus commission (5%), closing costs (2%), loan payoff, prorated expenses, and taxes.
- Depreciation recapture is taxed at up to 25%—significantly higher than the 15% LTCG rate.
- NIIT adds 3.8% on investment income for taxpayers above $200K (single) / $250K (married) MAGI.
- Model base, optimistic, and conservative scenarios to establish a realistic after-tax proceeds range.
Gross sale price is vanity; net proceeds are sanity. Investors routinely overestimate their disposition profits by neglecting commissions, closing costs, loan payoff, depreciation recapture, and capital gains taxes. This lesson walks through the complete net proceeds waterfall so that every disposition decision is grounded in the actual cash the investor will receive.
Process Flow
The Net Proceeds Waterfall
Net proceeds are calculated by subtracting all costs and obligations from the gross sale price in a specific order. Start with gross sale price ($350,000 in our reference example). Subtract selling commission (5% = $17,500). Subtract closing costs (2% = $7,000, covering title insurance, transfer taxes, attorney fees, recording fees). Subtract outstanding loan balance ($220,000). Subtract prorated property taxes and HOA dues (estimated $1,500). The result is pre-tax net proceeds of $104,000. Then apply capital gains taxes: long-term capital gains at 15% plus Net Investment Income Tax (NIIT) at 3.8% on the taxable gain, which accounts for depreciation recapture. In our reference case, total capital gains tax of approximately $18,900 reduces final after-tax net proceeds to approximately $85,100.
| Line Item | Amount | Cumulative | Notes |
|---|---|---|---|
| Gross Sale Price | $285,000 | $285,000 | Based on CMA and appraisal |
| Less: Seller Agent Commission (3%) | ($8,550) | $276,450 | Negotiable; 2.5-3% typical for investor accounts |
| Less: Buyer Agent Commission (2.5%) | ($7,125) | $269,325 | Post-NAR settlement: buyer may pay directly |
| Less: Closing Costs (Title, Transfer) | ($4,275) | $265,050 | ~1.5% of sale price |
| Less: Prorated Taxes & HOA | ($1,200) | $263,850 | Varies by closing date |
| Net Sale Proceeds | $263,850 | $263,850 | Amount received at closing |
| Less: Original Purchase Price | ($185,000) | $78,850 | Acquisition basis |
| Less: Renovation Costs | ($52,000) | $26,850 | Capital improvements (added to basis) |
| Less: Holding Costs | ($8,400) | $18,450 | 6 months × $1,400/mo (mortgage, insurance, utilities) |
| Less: Acquisition Closing Costs | ($3,700) | $14,750 | Title, recording, loan origination |
| Gross Profit | $14,750 | $14,750 | Before income tax |
| Less: Federal + State Tax (~32%) | ($4,720) | $10,030 | Short-term capital gain = ordinary income rate |
| Net After-Tax Profit | $10,030 | $10,030 | True bottom-line profit on this flip |
Source: Model based on NAR transaction cost benchmarks and IRS tax treatment for short-term capital gains (held < 12 months). ROI on cash invested: 10.3%.
Depreciation Recapture: The Hidden Tax
Depreciation recapture is the tax assessed on the difference between the sale price and the depreciated book value (adjusted basis) of the property. Residential investment property is depreciated over 27.5 years using straight-line depreciation. If you purchased a property for $280,000 (with $230,000 allocated to the structure and $50,000 to land) and held it for 5 years, you claimed $41,818 in depreciation ($230,000 / 27.5 × 5). Your adjusted basis is $238,182 ($280,000 − $41,818). Depreciation recapture is taxed at a maximum federal rate of 25%—higher than the 15% long-term capital gains rate. This means a portion of your gain is taxed more heavily. Investors who fail to account for depreciation recapture systematically overestimate their after-tax proceeds.
| Tax Component | Rate | Applies To | Reference Amount |
|---|---|---|---|
| Long-Term Capital Gains | 0% / 15% / 20% | Gain above adjusted basis (excluding recapture) | Based on taxable income bracket |
| Depreciation Recapture | 25% max | Accumulated depreciation claimed | $41,818 in 5-year example |
| Net Investment Income Tax | 3.8% | Total gain (if MAGI > $200K single / $250K married) | Full capital gain amount |
| State Income Tax | Varies 0-13.3% | Full capital gain | State-dependent |
Federal tax components affecting disposition proceeds
Source: IRS Publication 544, 2024
Scenario Modeling for Decision Support
Before committing to a disposition, model at least three scenarios: Base Case (expected sale price based on comparable sales), Optimistic Case (sale price 5-10% above comps, reflecting potential bidding competition or market upswing), and Conservative Case (sale price 5-10% below comps, reflecting longer days on market or market softening). Run the full net proceeds waterfall for each scenario and compare after-tax results. This range of outcomes provides the decision-maker with a realistic band of expected proceeds rather than a single-point estimate that implies false precision.
| Holding Period | Tax Treatment | Single Filer ($) | Married Filing Jointly ($) | Tax Rate |
|---|---|---|---|---|
| < 12 months | Short-term (ordinary income) | Based on bracket | Based on bracket | 10-37% |
| 12+ months, Income < $47,025/$94,050 | Long-term capital gain | $0-$47,025 | $0-$94,050 | 0% |
| 12+ months, Income $47,026-$518,900/$583,750 | Long-term capital gain | $47,026-$518,900 | $94,051-$583,750 | 15% |
| 12+ months, Income > $518,900/$583,750 | Long-term capital gain | $518,901+ | $583,751+ | 20% |
| Any period, NIIT threshold | Net Investment Income Tax | $200,000+ | $250,000+ | +3.8% |
| Depreciation recapture | Section 1250 gain | All brackets | All brackets | 25% (max) |
Source: IRS Tax Rate Schedules for 2024 (Rev. Proc. 2023-34). State taxes are additional. Depreciation recapture applies to rental properties held > 12 months.
Key Takeaways
- ✓Net proceeds waterfall: gross price minus commission (5%), closing costs (2%), loan payoff, prorated expenses, and taxes.
- ✓Depreciation recapture is taxed at up to 25%—significantly higher than the 15% LTCG rate.
- ✓NIIT adds 3.8% on investment income for taxpayers above $200K (single) / $250K (married) MAGI.
- ✓Model base, optimistic, and conservative scenarios to establish a realistic after-tax proceeds range.
Sources
Common Mistakes to Avoid
Forgetting to account for depreciation recapture when calculating net proceeds
Consequence: Depreciation recapture at 25% can add $10,000-$50,000+ in unexpected tax liability on a property held for several years
Correction: Always calculate cumulative depreciation taken and model the 25% recapture tax as a separate line item in the net proceeds waterfall
Using the original purchase price instead of adjusted basis for gain calculations
Consequence: Adjusted basis (purchase price + improvements − depreciation) is typically 15-30% lower than original price, significantly understating taxable gain
Correction: Track all capital improvements and annual depreciation to maintain an accurate adjusted basis throughout the holding period
Overlooking state capital gains taxes in net proceeds modeling
Consequence: States like California (13.3%), New York (8.82%), and Oregon (9.9%) add substantial tax liability that can eliminate the advantage of one exit vehicle over another
Correction: Include state income tax rates in all disposition models—some states have no capital gains tax while others exceed 10%
Test Your Knowledge
1.What is the maximum federal tax rate on depreciation recapture for real property?
2.At what MAGI threshold does the Net Investment Income Tax (NIIT) apply for single filers?
3.In a net proceeds waterfall, which cost is typically deducted first from the gross sale price?