Your home is often your family’s most significant investment. And with the recent skyrocketing of real estate prices, you might decide to sell your home and profit from the equity increase. But will you be taxed on the gain?
Every state has different tax laws. If you live in California, you need to know if California has a capital gains tax on real estate and how it works.
Are Capital Gains on a Residential Sale Taxed in California?
A capital gain is simply the increase in value of an asset from when you purchased it. When you sell the asset and take the profit, you “realize” the gain and may have to pay a tax on that capital gain.
Some states don’t tax capital gains, and others don’t tax capital gains on residential sales. But California does tax capital gains on residential sales in the state.
How the California Capital Gains Tax Works
When you sell an asset for profit in California, you will be taxed on the capital gain you make. This applies to stock, bonds, real estate, cars, and most other assets you sell.
California does not have a separate capital gains tax rate, unlike some jurisdictions. California taxes you on the profit of your residential sale as if it were ordinary income you earned. The tax rate will depend on your marginal tax when calculating your California income tax.
The California capital gains tax applies to profits you make when you sell certain like cars, stocks, bonds, and real estate. These profits are taxed as regular income. When calculating your California capital gains tax, you need to know your marginal tax bracket.
The California capital gains tax is calculated using the following formula:
Capital Gain = Sale Price of Asset – Adjusted Basis – Selling Expenses
Let’s say you bought a house in San Diego for $600,000 and then sold it for $800,000. Your capital gain would be $200,000 ($800,000 – $6000,000). If your expenses, like real estate commissions, were $20,000, your capital gain would be reduced to $180,000.
And if you made improvements on the house, like a roof or a pool, of $50,000, your adjusted basis would be the $600,000 you paid for the house, plus the $50,000 improvement, or $650,000.
So your taxable capital gain is $150,000.
The 2-in-5-Year Rule
California follows the IRS rules that allow you to exclude a certain amount of the gain you make on your home if you meet certain qualifications. Qualifying individuals can exclude $250,000, and qualifying couples can exclude $500,000.
You can take the exclusion if:
During the 5 years before you sell your home, you have at least:
- 2 years of ownership and
- 2 years of use as a primary residence
Also, you can only have one home at a time, and it must be one of the following:
- Mobile home
- Cooperative apartment
As an individual, if the gain from the sale was less than $250,000, you do not owe a capital gain tax, and you do not need to report the sale. You must report the sale if the gain is higher; any gain over $250,000 is taxable.
If you bought a house in Los Angeles for $500,000, owned it and lived in it for five years, and then sold it for $700,000, you have a capital gain is $2000,000. Under the 2 in 5 rules, you owe no taxes and do not have to report the sale.
The California rules for married couples or Registered Domestic Partners (RPD) are similar.
These couples can exclude up to $500,000 if all of the following apply:
- The gain from the sale was less than $500,000
- The couple filed a joint return for the year of sale or exchange
- Either spouse or RDP meets the 2-out-of-5-year ownership requirement
- Both spouses and RDPs meet the 2-out-of-5-year use requirement
- Neither spouse nor RDP excluded gain from the sale of another home in the last 2 years
Any gain over $500,000 is taxable.
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California Capital Gains Rate vs. Previous Years
California has no specific capital gains tax rates but imposes the regular California income tax rate on any capital gain. California has nine tax brackets:
1%, 2%, 4%, 6%, 8%, 9.3%, 10.3%, 11.3% and 12.3%.
California vs. Other Large U.S. States
Here is a quick comparison of California’s capital gains tax rate to other large US states:
- Texas: no state capital gains tax
- New York: 12.70%
- Florida: between 0% and 20%.
California’s tax on capital gains may be easy to calculate but is actually higher than many states. For example, Texas has no state tax on capital gains.
Short-Term vs. Long-Term Capital Gains Tax Rate in California
For federal tax purposes, the IRS differentiates between short-term, one year or less, and long-term, more than one year, capital gains, and they are taxed at different rates. The federal tax rate on short-term capital gains is the same rate as on your “ordinary” income, which ranges from 10% to 37%, depending on your taxable income. For long-term capital gains, the IRS taxes you either 0%, 15%, or 20%.
Gains from the sale of stocks, mutual funds, and most other capital assets that you held for more than one year, which are considered long-term capital gains, are taxed at either a 0%, 15%, or 20% rate depending upon the amount of the gain and what filing status you have.
But, California does not distinguish between short-term and long-term. All capital gains are taxed at your marginal income tax rate no matter how long you held the assets.
How The Capital Gains Tax Is Calculated In California
California calculates capital gains tax by taking the asset’s sale price and subtracting the cost basis, which is the purchase price you paid plus the cost of any improvements you made. In real estate, it is common to fix up the property and make improvements.
The amounts you spend on the property will adjust the cost basis of your real estate and lessen the capital gains tax burden when you sell the property.
How To Avoid California Capital Gains Tax
The best way to avoid capital gains tax on the sale of your California residential real estate is to take full advantage of the exemption. In California, a single taxpayer can save up to $250,000. And married couples or Registered Domestic Partners can save up to $500,000 using the capital gains real estate tax exemption. To qualify, you must live in the home for two of the five years before the sale.
And even if you don’t qualify for a total exemption, you might be eligible for a partial exemption in California.
For example, suppose you could not live in the home for the entire two years because of a medical condition, death in the family, or sudden need to move because of employment. In that case, a partial exemption may be possible.
Another way to reduce your capital gains taxes is to increase the cost basis of the house by including expenses associated with the property purchase, certain fees, additions, and home improvements. This increase in cost basis offsets and reduces your capital gains.
How to Report Your Home Sale in California for Capital Gains Taxes
When reporting the capital gain on the sale of your residential house, you need to fulfill the federal tax reporting requirements. And in California, you also need to file a California Capital Gain or Loss Schedule D 540 form package if your home sale created a gain for you above the $250,000 or $500,000 exclusion limits.
What About Selling a California Home You Inherited?
You will not have to pay inheritance taxes if you inherit a California home. If you later sell the home, you will be responsible for paying capital gains taxes. But the good news is that the cost basis for you is not the original purchase price of the house when it was bought. The cost basis is “stepped-up” to the value when you inherited the property. The original cost basis is wiped clean. This can save you thousands of dollars in capital gains taxes.
Here are the answers to some common questions about how California taxes the sale of your primary residence.
Unless your second home qualifies under the 2-in-5 rule explained above, you will owe capital gains taxes on the sale if you sell for a profit.
You do not pay capital gains taxes if you sell your home at a loss.
Generally speaking, you must own the house for at least two years, plus meet the other qualifications.
California Propositions 60/90 amended the California Constitution to allow a person over age 55 to sell his or her principal place of residence and transfer its base year value to a replacement dwelling of equal or lesser value that is purchased or newly constructed within two years of the sale.
Using a 1031 exchange program can avoid or defer capital gains taxes if you purchase another like-kind property. However, personal residences do not qualify for 1031 exchanges for California or federal tax purposes.