How Much Is Capital Gains Tax on Real Estate in California?

Capital gains tax on real estate involves both federal and state regulations. Understanding these implications is important for anyone selling property for a profit. Navigating the rules and potential tax liabilities requires careful consideration of how gains are calculated and which exclusions or special tax treatments might apply. This understanding aids in financial planning and managing property sales.

Calculating Your Taxable Gain

Calculating the taxable gain from a real estate sale starts with determining the “amount realized.” This is the selling price minus selling expenses like real estate commissions, legal fees, and title insurance. For example, if a property sells for $800,000 with $50,000 in expenses, the amount realized is $750,000.

Next, establish the property’s “adjusted basis.” This includes the original purchase price and acquisition costs like legal fees, recording fees, and transfer taxes. The adjusted basis is then modified by adding the cost of capital improvements and subtracting certain deductions, such as depreciation if the property was used for business or rental purposes. Capital improvements are significant updates that add value, prolong the property’s useful life, or adapt it to new uses, such as adding a new roof or renovating a bathroom. Routine repairs and maintenance are generally not considered capital improvements and do not increase the basis.

The taxable gain is the difference between the amount realized and the adjusted basis. For instance, if the adjusted basis was $500,000 and the amount realized was $750,000, the capital gain is $250,000. A higher adjusted basis from documented improvements can reduce the overall taxable gain.

Federal Capital Gains Tax

Federal capital gains tax depends on how long the real estate asset was held. Gains from assets held for one year or less are short-term capital gains, taxed at ordinary income tax rates (10% to 37%) based on the taxpayer’s overall income and filing status.

Assets held for more than one year yield long-term capital gains, which typically have lower, preferential tax rates. Federal long-term capital gains tax rates are 0%, 15%, or 20%. The specific rate applied depends on the taxpayer’s taxable income and filing status. For example, the 0% rate might apply to single filers with taxable income below certain thresholds.

High-income taxpayers may also face the Net Investment Income Tax (NIIT). This 3.8% surtax applies to certain investment income, including capital gains. The NIIT applies to individuals with a modified adjusted gross income (MAGI) exceeding specific thresholds, such as $200,000 for single filers or $250,000 for those married filing jointly. This additional tax can increase the total federal tax liability.

California Capital Gains Tax

California’s approach to taxing real estate capital gains differs significantly from federal law. The state does not have a separate, lower tax rate for capital gains. Instead, all capital gains, regardless of how long the asset was held, are treated as ordinary income.

California has a progressive income tax system, with rates increasing as income rises, ranging from 1% to 12.3%. For high-income earners, an additional 1% mental health services tax applies to income over $1 million, raising the top marginal rate to 13.3%. This unified treatment of capital gains as ordinary income can result in a significant tax liability for California residents selling real estate.

Unlike the federal system, California does not distinguish between short-term and long-term capital gains for tax rate purposes. Consequently, the profit from selling a property held for many years will be taxed at the same state income tax rate as a property held for a shorter period.

Principal Residence Exclusion

The Section 121 exclusion offers a tax benefit for homeowners selling their principal residence. Eligible taxpayers can exclude a portion of the gain from their gross income, up to $250,000 for single filers and $500,000 for married filing jointly. This exclusion can significantly reduce or eliminate federal and state tax liability on a home sale.

To qualify, taxpayers must meet both an ownership and a use test. The ownership test requires owning the home for at least two years out of the five-year period ending on the sale date. The use test requires using the home as a principal residence for at least two years out of the same five-year period. These two-year periods do not need to be consecutive.

The exclusion can generally be claimed once every two years. It applies specifically to a principal residence and cannot be used for gains from vacation homes or investment properties.

Depreciation Recapture

Depreciation recapture applies when a depreciable asset, like real estate used for business or rental purposes, is sold for a gain. This happens because prior depreciation deductions reduced the property’s adjusted basis, increasing the potential gain. The previously deducted depreciation is “recaptured” and taxed upon sale.

Federally, recaptured depreciation on real property (known as unrecaptured Section 1250 gain) is generally taxed at a maximum rate of 25%. This rate is distinct from the general long-term capital gains rates. Any gain exceeding the recaptured depreciation is then subject to the standard long-term capital gains rates. This 25% rate applies to the straight-line depreciation taken.

California also taxes depreciation recapture as ordinary income, consistent with its treatment of other capital gains. The recaptured depreciation is added to the taxpayer’s total income and is subject to California’s progressive income tax rates, which can reach 13.3% for top earners. This can significantly impact the tax liability for investors selling depreciated real estate.