California taxes capital gains from real estate at its regular income tax rates, without the preferential long-term capital gains rates available under federal law. Depending on the transaction, California real estate withholding may also be required at closing.
Understanding how federal and California tax rules apply to a property sale can help investors avoid unexpected tax liabilities and identify potential planning opportunities.
At Robert Hall & Associates, our tax consultants work with property owners and investors throughout Los Angeles and California. Coordinating federal and state tax obligations is an important part of our real estate tax preparation services.
How Much Is Capital Gains Tax on Real Estate in California?
Both federal and California income taxes may apply to the gain from selling real estate.
For investment property held longer than one year, federal tax considerations may include:
- 0%, 15%, or 20% federal long-term capital gains tax, depending on taxable income and the type of gain
- An additional 3.8% Net Investment Income Tax for certain higher-income taxpayers
- Special depreciation-related gain rules, including unrecaptured Section 1250 gain that may be taxed at a maximum federal rate of 25%
California does not provide a separate preferential rate for long-term capital gains. Instead, gains are generally taxed using the state’s regular income tax brackets.
California’s highest regular individual income tax rate is 12.3%, with an additional 1% tax applying to taxable income above $1 million, bringing the highest marginal rate to 13.3%.
The actual tax owed depends on factors such as the property’s adjusted basis, improvements, depreciation, holding period, selling expenses, and the taxpayer’s overall income.
Selling property held for one year or less generally results in short-term gain, which is typically taxed at ordinary federal income tax rates rather than preferential long-term capital gains rates.
California FTB Withholding on Real Estate Sales
California generally requires real estate withholding on applicable property sales. The withholding is administered through the Franchise Tax Board (FTB) and reported using Form 593.
The standard calculation is 3⅓% of the sales price, but eligible sellers may elect an alternative calculation based on taxable gain.
For individual sellers, the alternative withholding rate is generally 12.3% of the calculated gain.
For example, the standard withholding calculation on a $1.2 million fourplex in Highland Park would be approximately $40,000.
However, the actual withholding requirement may differ depending on the seller’s eligibility for an exemption or alternative calculation.
Certain transactions may qualify for withholding exemptions, including:
- Eligible principal residence sales meeting applicable exclusion and certification requirements
- Qualifying sales at a loss
- Certain foreclosure transactions
- Other transactions meeting specific California withholding exemptions
The applicable Form 593 requirements must be satisfied, and sellers should review their eligibility before assuming withholding is unnecessary.
California real estate withholding is a prepayment of state income tax, not the final tax liability. The amount withheld is generally claimed as a credit on the seller’s California income tax return.
What Are the 1031 Exchange Rules in California?
A properly structured Section 1031 like-kind exchange may allow investors to defer recognizing gains when exchanging qualifying real property held for investment or productive use in a trade or business.
A 1031 exchange is not simply a matter of selling property and reinvesting the proceeds. Strict identification, timing, and other requirements apply, including the general 45-day identification and 180-day exchange completion deadlines.
California generally follows federal like-kind exchange treatment for qualifying real property. However, additional California reporting requirements can apply when California property is exchanged for replacement property located in another state.
Under the FTB’s like-kind exchange rules, California generally requires Form FTB 3840 for the year of an exchange involving California real property and out-of-state replacement property.
The form generally must also be filed in subsequent years until the deferred California-source gain or loss is recognized.
For example, an investor who exchanges a California rental property for qualifying replacement property in Arizona or Texas may defer the gain under federal and California rules.
However, California generally retains the right to tax the deferred California-source gain when it is eventually recognized, even if the replacement property is located outside California.
This treatment is sometimes informally called California’s 1031 exchange “clawback” rule.
Does the Home Sale Exclusion Cover a Former Rental?
The federal home sale exclusion may allow eligible homeowners to exclude up to $250,000 of gain, or up to $500,000 for certain married couples filing jointly, when selling a qualifying principal residence.
Generally, the homeowner must have owned and used the property as a principal residence for at least two of the five years preceding the sale. Additional eligibility requirements apply.
The IRS provides further information through its home sale exclusion guidance.
Properties that were previously used as rentals require additional consideration.
If a property was rented before becoming a principal residence, certain periods of nonqualified use after 2008 may reduce the amount of gain eligible for the home sale exclusion. Specific exceptions apply.
Depreciation also affects the calculation.
Gain attributable to depreciation deductions allowed or allowable for rental or business use after May 6, 1997 generally cannot be excluded under the home sale exclusion and may be subject to separate federal tax treatment.
For property owners who have converted a rental into a principal residence, or vice versa, reviewing the property’s use history and depreciation records before selling is particularly important.
How to Reduce Capital Gains Tax on Property in California
A 1031 exchange is one potential strategy for qualifying investment real estate, but other approaches may be available depending on the property, the seller’s objectives, and applicable tax rules.
Common planning strategies include:
- Installment Sale: An eligible property sale structured with payments over multiple tax years may allow some gain to be recognized as payments are received. However, depreciation recapture and certain other amounts may be taxable in the year of sale.
- Qualified Opportunity Funds: Certain eligible investments may provide federal capital gains tax benefits under applicable Opportunity Zone rules. Eligibility, investment timing, and available benefits depend on current law. California generally does not conform to the federal Opportunity Zone tax incentives.
- Charitable Remainder Trust: In certain circumstances, transferring appreciated property to a properly structured charitable remainder trust before a sale may provide tax-planning benefits while creating an income stream for designated beneficiaries. These arrangements involve complex requirements and do not eliminate all tax obligations.
Each strategy has its own eligibility requirements, timing considerations, and potential costs.
For example, installment-sale terms generally must be established as part of the transaction, while transferring property to a charitable remainder trust requires careful planning before a binding sale obligation arises.
Opportunity Zone investments follow separate federal requirements and deadlines, which should be reviewed under the law applicable to the investment.
These strategies should be evaluated based on both federal and California tax consequences rather than assuming a federal tax benefit will automatically produce the same result on the state return.
Plan Your Los Angeles Property Sale Before Escrow Opens
California real estate withholding, 1031 exchanges, installment sales, and other tax strategies should be evaluated before a transaction closes. Some strategies require planning well before closing to preserve eligibility.
Property owners should also review their adjusted basis, depreciation history, estimated gain, selling expenses, and potential federal and California tax obligations before finalizing a sale.
Robert Hall & Associates works with individual property owners, real estate investors, and businesses throughout Los Angeles and California to help evaluate these considerations.
Our tax consultants can review the details of a proposed transaction, estimate potential federal and California tax liabilities, and identify planning opportunities that may apply to your situation.
Call (818) 242-4888 for a complimentary discovery call or share your property sale details online to discuss your next steps.