Capital Gains Tax on a Primary Residence in California

When selling a primary residence in California, homeowners face potential tax implications at both the federal and state levels. The profit from selling a home is a capital gain and can be subject to taxation. Understanding federal exclusions and California’s specific tax rules is necessary for any homeowner considering a sale, as both jurisdictions have regulations that determine how much gain, if any, is taxable.

The Federal Primary Residence Exclusion

The Internal Revenue Code (IRC) provides a tax benefit for homeowners selling their primary residence. Under Section 121, a single individual can exclude up to $250,000 of the gain from their taxable income, while a married couple filing a joint return can exclude up to $500,000. This exclusion can be used multiple times, provided the qualifying conditions are met for each sale.

To qualify, homeowners must satisfy two main tests. The Ownership Test requires owning the home for at least two years during the five-year period ending on the sale date. The Use Test requires living in the home as a primary residence for at least two of the five years preceding the sale, though these two-year periods do not need to be continuous.

A homeowner who does not meet the two-year requirements may be eligible for a partial exclusion if the sale is due to an unforeseen circumstance. The IRS defines these circumstances to include a change in employment, health reasons, or other events like a natural disaster or divorce. The reduced exclusion is prorated based on the portion of the two-year period the homeowner met the requirements.

For example, a single individual who lives in their home for one year before moving for a new job has met 50% of the requirement. They may be able to exclude up to 50% of the standard $250,000 exclusion, which amounts to $125,000 of their capital gain.

Calculating Your Home’s Capital Gain

To determine the capital gain on a home sale, subtract the adjusted basis from the selling price. The selling price is the gross amount less any selling expenses, which include real estate agent commissions, title fees, and legal fees. These deductions reduce the overall proceeds and the potential gain.

The “adjusted basis” begins with the home’s original purchase price. This basis is then increased by the cost of capital improvements, which are investments that add value to the home, prolong its life, or adapt it to new uses. Examples include adding a new room, installing a new roof, or remodeling a kitchen.

In contrast, repairs and maintenance like painting a room or fixing a leaky faucet do not increase the adjusted basis. These are expenses to keep the home in good condition but do not add to its value.

Certain events can decrease a home’s basis. If a homeowner claimed depreciation deductions for a home office or for using the property as a rental, these amounts must be subtracted from the basis. A lower basis results in a higher capital gain.

California State Tax Treatment

California conforms to the federal primary residence exclusion. If the gain from a home sale is fully covered by the federal exclusion, it is also not taxed by California.

The primary difference in California’s tax treatment arises when a capital gain exceeds the exclusion amount. Unlike the federal system, which has lower tax rates for long-term capital gains, California does not distinguish between short-term and long-term gains. Any taxable profit from a home sale is treated as ordinary income and taxed at the individual’s marginal state income tax rate.

This treatment can lead to a higher state tax liability. For example, a high-income taxpayer could face a federal long-term capital gains rate of 15% or 20% on their gain. In California, that same gain is added to their other income and could be taxed at rates up to 13.3%, depending on their tax bracket.

Reporting the Home Sale

You must report a home sale on your tax return if you receive a Form 1099-S, Proceeds From Real Estate Transactions, even if you owe no tax. This form is issued by the escrow company or closing agent. If you do not receive a Form 1099-S, you do not need to report the sale if the entire gain is excludable.

For federal purposes, taxpayers use Form 8949, Sales and Other Dispositions of Capital Assets, to detail the sale. The totals from this form are then transferred to Schedule D, Capital Gains and Losses, which is filed with your Form 1040.

On the state level, California taxpayers report the sale using the California Schedule D (540). This form is used to calculate the capital gain or loss for state tax purposes. Any taxable gain is then carried over to the main California tax return, Form 540, to be taxed as ordinary income.