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California Capital Gains Tax on Real Estate

June 27, 2024

The California tax law requires that you pay taxes on the gain you realize when you sell a capital asset. This tax is called capital gains tax. As a real estate investor in California, you need to understand how to accurately calculate the capital gains tax and file the tax returns at both the federal and state levels to avoid tax errors and the corresponding legal consequences.

However, there are various strategies and tax loopholes you can leverage to reduce or defer your capital gains tax liability, thereby reducing your overall taxable income. Such strategies include the 1031 exchange and the primary residence exclusion. To successfully exempt or defer capital capital gains tax, you must also play by the rules, which means you have to understand and follow all the requirements stipulated by the IRS.

Our expert qualified intermediary at Universal Pacific 1031 Exchange is always available to help you facilitate a 1031 exchange to defer capital gains tax hasslefree. We’ve facilitated thousands of successful tax-deferred exchanges in over 32 years; hence we have the required experience to guide you through the 1031 exchange process with ease. Book a free consultation with us now to begin your exchange!

This comprehensive guide covers what capital gains tax is, the California capital gains tax rates, and how Universal Pacific 1031 Exchange can help you defer capital gains tax through a successful 1031 exchange.

Understanding California Capital Gains Tax on Real Estate

Understanding California Capital Gains Tax on Real Estate

Capital gains tax refers to the tax you pay on the profit you earn when you sell an asset. It applies to various assets, including real estate, stocks, bonds, and other kinds of investments. In real estate, you calculate capital gain as the difference between the selling price of a property and the adjusted basis of that property. The adjusted basis is calculated as the original purchase price plus improvements minus depreciation.

The calculation of capital gains taxes depends on how long the property was held. The holding period starts counting from the day you acquired the property to (including) the day you sold it.

Based on the holding period, there are two types of capital gains: short-term capital gains and long-term capital gains. Short-term capital gains apply to properties that were held for one year or less before they were sold. Short-term capital gains are taxed at the seller’s ordinary income tax rate. On the other hand, long-term capital gains apply to properties that were held for more than a year before they were sold. Long-term capital gain tax rates are usually lower than short-term tax rates at the federal level, but are taxed at the same rates as short-term capital gains in California.

California Capital Gains Tax Rates

According to the Franchise Tax Board of the State of California (FTB), there is no difference between short and long-term capital gains taxes. Both short-term and long-term capital gains are subject to California’s regular state income tax rates, ranging from 1% to 13.3% depending on the taxpayers income level.

As specified by the FTB, the California capital gains tax rates for different income brackets are as follows:

  • 1% tax rate for taxable income of $0 to $10,412 for single filers, and $0 to $20,684 for married filing jointly.
  • 2% tax rate for taxable income of $10,412 to $24,684 for single filers, and $20,824 to $49,368 for married filing jointly.
  • 4% tax rate for taxable income of $24,684 to $38,959 for single filers, and $49,368 to $77,918 for married filing jointly.
  • 6% tax rate for taxable income of $38,959 to $54,081 for single filers, and $77,918 to 108,162 for married filing jointly.
  • 8% tax rate for taxable income of $54,081 to $68,350 for single filers, and $108,162 to $136,700 for married filing jointly.
  • 9.3% tax rate for taxable income of $68,350 to $349,137 for single filers, and $136,700 to $698,274 for married filing jointly.
  • 10.3% tax rate for taxable income of $349,137 to $418,961 for single filers, and $698,274 to $837,922 for married filing jointly.
  • 11.3% tax rate for taxable income of $418,961 to $698,271 for single filers, and $837,922 to $1,396,542 for married filing jointly.
  • 12.3% tax rate for taxable income of $698,271 AND ABOVE for single filers, and $1,396,542 AND ABOVE for married filing jointly.
  • An additional 1% tax (Mental Health Services Tax) on income over $1 million, making the effective top rate 13.3% for incomes over $1 million.

Federal Capital Gains Tax Rates

Federal capital gains tax rates depend on whether your capital gains are short-term or long-term. Short-term capital gains are taxed at ordinary income tax rates, between 10% to 37%, depending on the taxpayer’s income. Long-term capital gains are taxed at relatively lower rates, from 0% to 20%, depending on the taxpayer’s income.

For long-term federal capital gains taxes:

  • 0% tax rate applies to taxable income of up to $44,625 for single filers, and up to $89,250 for married couples filing jointly.
  • 15% tax rate applies to taxable income between $44,626 and $492,300 for single filers, between $44,626 and $276,900 for married couples filing separately, and between $89,251 and $553,850 for married couples filing jointly.
  • 20% tax rate applies to taxable income of over $492,300 for single filers, and over $553,850 for married couples filing jointly.

Example Calculating Capital Gains Tax

Suppose you sell an investment property in California with a profit of $100,000 after holding the property for two years.

To calculate your federal capital gains tax:

With a total taxable income of $100,000, you qualify for 15% capital gains tax bracket. Thus, the federal capital gains tax will be:

  • $100,000 x 15% = $15,000

To calculate California capital gains taxes:

Using the California online tax calculator provided by the FTB, with a total taxable income of $100,000, your California capital gains tax will be:

  • $5,951 if you’re a single filer, at 5.951%
  • $3,245 for a married couple filing jointly, at 3.245%
  • $5,951 for a married couple filing separately, at 5.951%

Exemptions and Deductions on California Capital Gains Tax

Exemptions and Deductions on California Capital Gains Tax

As a real estate investor in California, you should be aware of the several exemptions and deductions that you can take advantage of to reduce your taxable income. Thankfully, these deductions are all legally recognized, so you don’t have to worry about compliance as long as you follow all the rules guiding them. Such exemptions and deductions include:

1. Primary Residence Exclusion

This is the most significant exemption for people selling their homes in California. Under the Primary Residence Exclusion, when you sell your primary residence, you can exclude up to $250,000 of capital gains for single filers, and up to $500,000 of capital gains for married couples filing jointly.

To qualify for the primary residence exclusion, you must fulfill both the ownership test and the use test.

  • The ownership test implies that you must have owned the home for at least two years out of the five years preceding the sale of the primary residence.
  • The use test requires that you must have lived in the property as your main residence for at least two years out of five years immediately before the sale of the home.

Note that you can meet the ownership and use tests during different 2-year periods as long as it’s within the 5-year period ending on the date of the sale. You do not qualify for the exclusion if you had previously excluded the gain from the sale of another primary residence within the two-year period preceding the sale of your home.

2. Adjustments to Basis: Improvements and Depreciation

The adjusted basis of your property is one the most important factors in determining the capital gain of the sale. You can deduct certain costs and improvements to adjust the basis, thereby reducing the taxable gain. To begin with, you can deduct the costs that are directly associated with the sale of the home from the selling price, giving you the net proceeds. Such costs include legal fees, real estate commissions, inspection fees, and advertising costs.

You can also deduct the costs of major improvements that enhanced the value of the property. Examples of such improvement costs include upgrading the HVAC system, installing a new roof, or adding some new rooms. Additionally, if the property was used for rental purposes or business, you can subtract the real estate depreciation claimed during the period of ownership, which must be subtracted from the basis.

3. Loss Carryforward

If you incur capital losses, you can use them to offset capital gains. You can carry the remaining losses forward to future tax years if your capital losses exceed your capital gains. If the losses exceed the gains in a given year, you can deduct the excess loss against other income, up to $1,500 for people filing separately and up to $3,000 for married couples filing jointly.

4. The 1031 Exchange

The 1031 exchange was named after Section 1031 of the Internal Revenue Code. With a 1031 exchange, you can defer capital gains taxes by reinvesting all the sale proceeds of a relinquished property into a like-kind replacement property. That way, you get to pay capital gains taxes when you sell the new property instead of paying the taxes at the time of the sale of the old property. This strategy allows you to continue deferring capital gains taxes through subsequent exchanges as long as you adhere to the rules guiding the 1031 exchange.

Benefits of the 1031 Exchange

The primary benefit of the 1031 exchange is the ability to defer capital gains tax. The money you would have paid as capital gains tax becomes extra capital for reinvestment into the replacement property. Apart from deferring capital gains tax, a 1031 exchange also helps you strategically position your real properties for better market conditions. For instance, you can exchange empty land in a remote, less competitive area for an income-generating office complex in a developed area.

The strategy also helps you diversify your assets. For example, if you have a portfolio of five rental apartments, you can swap one of them for a shopping complex, adding a different type of potential income to your investment.

However, there are a few potential drawbacks you need to be aware of. To maximize the tax-deferral benefits, you must follow all the rules and requirements. Violating any of these rules may disqualify you from tax deferral, and you’ll be liable for tax immediately. Additionally, the time constraints may result in pressure that may affect the smooth running of your exchange. Moreover, the complexities of the exchange may be challenging for new investors.

The best way to avoid all these drawbacks is to work with our expert qualified intermediary at Universal Pacific 1031 Exchange. We’re always available to help you run a smooth and compliant exchange without any hassle. We also offer professional guidance throughout the process.

Eligibility Criteria for a 1031 Exchange

Eligibility Criteria for a 1031 Exchange

To qualify for tax-deferral through a 1031 exchange, both the relinquished and the replacement properties must be like-kind, according to the IRS. Secondly, both investments must be held for investment or business purposes. Therefore, personal use properties do not qualify.

According to the Tax Cuts and Jobs Act, capital gains tax deferral under Section 1031 applies only to exchanges involving real properties and not personal or intangible property. However, your exchange of personal or intangible property may still qualify if you sold the relinquished property on or before December 31, 2017, or received the replacement property on or before that date.

Another important requirement you need to be aware of is the timeline for a 1031 exchange. According to the IRS, you have a strict timeline of 180 days to complete a 1031 exchange. You must identify the replacement property within 45 days after the sale of the relinquished property. Then, you must acquire the replacement property and complete the purchase within the remaining 135 days. If you miss any of these deadlines, the IRS may disqualify your exchange and you would have to pay immediate capital gains taxes.

Furthermore, you must reinvest all sales proceeds of the relinquished property to qualify. Any portion of the sales proceeds that is not reinvested is known as boot in a 1031 exchange, and this portion is subject to tax.

Moreover, you’re not allowed to receive the sale proceeds of the relinquished property or have constructive receipt of the funds as a taxpayer. You must use the services of a Qualified Intermediary, also known as an exchange accommodator. The QI holds the proceeds from the sale of the relinquished property and uses them to acquire the replacement property.

Remember to follow the 1031 exchange identification rules while identifying your potential replacement properties. The fair market value of the replacement property must be equal to or greater in value than the relinquished property. You can identify up to three replacement properties provided that you adhere to the three-property rule, the 200% rule, and the 95% rule.

Strategies for Minimizing Capital Gains Tax in California

There are a number of strategic steps you can take to reduce your capital gains tax liability and boost your investment portfolio. However, you must have a proper understanding of how these strategies work to avoid legal mistakes that may prove costly eventually.

To begin with, invest in retirement accounts with tax advantages, such as IRAs and 401(k)s. You would not have to pay tax on capital gains in these types of accounts until you withdraw. You can even withdraw tax-free with Roth IRAs under specified conditions.

Another strategy is to hold your investments for more than one year to qualify for long-term capital gains tax rates, which are typically lower than short-term rates. Additionally, invest in qualified Opportunity Zones. Investments held for certain periods can qualify for additional tax benefits.

Moreover, you can take advantage of the 1031 exchange to defer capital gains tax. To qualify for this strategy, you swap one investment property for another replacement property of like-kind. Be careful to complete the transactions within the stipulated timeline and follow all other rules specified by the IRS for a 1031 exchange.

Capital Gains Filing and Reporting Requirements

Capital Gains Filing and Reporting Requirements

To stay compliant when you sell a property in California, you’ll have to report capital gains on both your federal and state tax returns. The first step is to calculate the capital gains or losses to get accurate figures. We’ve provided a summarized step-by-step guide below.

  1. Determine the sale price of the property.
  2. Deduct the expenses incurred during the sales, such as legal fees and commissions
  3. Calculate the adjusted basis by adding the improvements to the original purchase price and then subtract the depreciation
  4. Subtract the adjusted basis from the net proceeds to determine the capital gain.

For federal tax reporting, report capital gains on IRS Form 8949, “Sales and Other Dispositions of Capital Assets.” You should include details such as the date of acquisition, date of sale, sale price, cost basis, and any adjustments. Then, summarize the totals from Form 8949 on Schedule D (Form 1040).

For California capital gains tax reporting, fill out the California Schedule D (540), “California Capital Gain or Loss Adjustment.” Note that you do not have to complete this schedule if all of your California gains are the same as your federal gains.

You also need to make sure that your tax reports are filed on time. Federal tax return for capital gains is typically due by April 15 of the following year. California state capital gains tax return is also due by April 15 of the following year. For instance, for the tax year 2024, the deadline will be April 15, 2025.

Tips for Ensuring Accurate Filing of Capital Gains Tax

Tips for Ensuring Accurate Filing of Capital Gains Tax

Since filing capital gains tax returns inaccurately may attract legal and tax consequences, you need to learn how to do it the right way. Here, we’ve provided you with some pro tips on how to ensure accurate filing of capital gains tax.

  • Keep detailed records of the purchase price, improvements, selling expenses, and any depreciation claimed. It’s also important to save documents such as closing statements, receipts for improvements, and real estate commissions for future reference.
  • Make sure you use the correct federal and state forms to report your capital gains accurately.
  • Even if you didn’t make any gains, it’s best to include all sales and exchanges of capital assets.
  • Be aware of the differences between the federal tax rates and those of California so you can calculate accurately and avoid errors.
  • If your tax situation is complex, it might be better to hire a tax professional. For 1031 exchanges, you can consult our expert QI at Universal Pacific 1031 Exchange to guide you.

Have Questions about California Capital Gains Tax on Real Estate?

The capital gains tax is an important part of your tax returns as a real estate investor in California. That’s why it’s important to learn how to identify capital gains, the strategies that can help you defer the tax, and how to file your tax returns accurately. Remember that failure to adhere to the state tax rules may put you in trouble, disqualify you from tax benefits, and increase your tax liability.

If you’re looking to defer capital gains taxes through a 1031 exchange, Universal Pacific 1031 Exchange is the best-qualified intermediary in Los Angeles, California. We’ve been facilitating successful tax-deferred exchanges for over 32 years; you can trust us for a smooth and compliant exchange and expert guidance throughout the process. Book a free consultation with us today to discuss your transactions and start an exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.