The capital gain of $110,000 is correct. When you converted the property to a rental its adjusted basis was $250,000. When you sold the property its adjusted basis was $210.000 ($250,000 less $40,000 in depreciation). Your capital gain is selling price $320,000 less adjusted basis $210,000 which equals $110,000. What you owe and have to payoff is not a factor when computing capital gain on a rental property. Capital gain does not necessarily equal the cash you receive in a sale.
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