The federal and state capital gains tax on a real estate sale can substantially reduce an investor's bottom line. In addition, any depreciation recapture must be factored in as well. The capital gains on real estate investment sales can also be impacted by tax code changes that are made between the purchase and sale of the property.

Currently, depreciation recapture is taxed at 25 percent, the current federal capital gains rate is 15 percent and the state capital gains tax is specific to each state. The gain, not the profit or equity from a sale of real estate held for income or investment, is subject to the combination of federal and state capital gains taxes and the federal taxes due to the depreciation taken on the property.

For many years, investors whose overall income put them in the top four income-tax brackets faced a long-term capital gains rate of 20 percent, while lower-income investors paid capital gains taxes of 10 percent. Tax law changes in May 2003, however, lowered the rates by 5 percent each. Investors in the higher-income ranges, now find their capital gains taxed at 15 percent –– a substantial penalty based on the sale of property.

These rates were scheduled to end on Dec. 31, 2008 but have been extended through 2010.

Real estate investors seeking to defer capital gains taxes on the sale of property may utilize IRS Section 1031, which allows investors to "exchange" properties. In an exchange, where an investor wishes to completely defer any capital gains tax, the investor must invest in a property (or properties) that are equal or greater in value than the property that was sold, re-invest all of the equity in the newly purchased ("replacement property"), and maintain an equal or greater level of debt in the replacement property. As a result of the exchange, capital gains tax on the real estate investment sale is deferred.