California is known for a lot of fun and unique things, but in the taxes and accounting world, California is known for high taxes, and their capital gains tax is no exception.
In today’s article, I’ll explain everything you need to know about California’s capital gains tax, including how you might be able to avoid paying it.
What is a capital gains tax?
Before we dive into the specifics of the California capital gains tax, it’s important to have a basic understanding of what capital gains tax is and how it works. In general, capital gains tax is a tax on the profits you make from selling certain types of assets. These assets can include stocks, bonds, real estate, and other investments.
When you sell an asset and make a profit from that sale, then the capital gains tax is applied to the amount of profit you made. For example, let’s say you bought a stock for $1,000 and sold it for $1,500. Your profit would be $500, and you would be taxed on that amount. The tax rate you’d pay on this profit often depends on various factors, such as your income, the length of time you held the asset, and the type of asset you sold.
What is different about California’s capital gains tax?
States have different methods for calculating capital gains tax and for deciding which types of sales are included in the tax. Some states tax capital gains as income by applying the state’s income tax rates to long-term and short-term capital gains. Some states don’t charge capital gains tax (or income tax) at all.
However, in California, capital gains tax does apply and–unlike in most places–it can even apply to the sale of your home.
Does California’s capital gains tax apply to the sale of my home?
When selling your home, the rules for California’s capital gains tax align with the federal government’s IRS tax rules. This means that you can exclude up to a certain amount of the profit you make when selling your home if you meet the following requirements:
- You meet the “two-out-of-five-year” rule (read on for more about this).
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Your home is one of these required/recognized types:
- Condominium
- Cooperative home
- House
- Houseboat
- Mobile home
- Trailer
- You’re only applying the exclusion to one home at a time.
- You haven’t used this exclusion within the last two years.
- Your profit from the sale is below $250,000 for individual filers and under $500,000 for joint filers. (Any profit above those amounts is taxed.)
What is the “two-out-of-five-year” rule?
To qualify for the capital gains tax exemption when selling your home, you must meet the two-out-of-five-year rule. This rule says that if you owned your home for at least two of the five years prior to selling it and you used your home as your primary residence in at least two of the five years prior to selling it, then you can qualify for the exclusion from capital gains on the sale of that home. An important note is that the two years of ownership and the two years of residence don’t have to be the same two years.
Are there special rules for joint filers wanting to use the capital gains exclusion when selling their home in California?
If filing California taxes as married or registered domestic partners (RDP), there are a few things to note if trying to exclude the sale of your home from capital gains tax. First, only one spouse or RDP needs to meet the two-out-of-five-year ownership requirement but both spouses must meet the two-out-of-five-year primary residence requirement. Also, neither of the spouses or RDPs can have excluded capital gains from the sale of a different home within the last two years.
How much capital gains tax will I pay in California?
Your income level determines the tax rate that applies to your capital gains in California. Like the federal income tax system, California has a progressive income tax system, which means that the more money you make, the higher your tax rate will be. In California, these rates range from 1% to around 13%. Remember that if you qualify for an exclusion, then the capital gains tax will only apply to the amount of profit you make beyond the amount that is excluded.
How can I avoid paying capital gains tax on real estate sales in California?
If you don’t qualify for the full capital gains tax exemption, you may qualify for a partial exemption if you have special circumstances. For instance, if you have to move due to a military placement, a divorce, or a death in the family, you may qualify for a partial exemption.
Additionally, you can increase what is called the “cost basis” for your home by adding the costs of home improvements to your purchase price. For instance, if you purchased your home for $200,000 and then spent $100,000 remodeling your home (and increasing its value), then the new cost basis for your home is $300,000.
If you then sell your home for $350,000 and don’t qualify for the capital gains exemption, you’d still only pay capital gains tax on $50,000 of profit ($350,000 – $300,000) rather than $150,000 of profit ($350,000 – $200,000). This can save you big bucks; just remember to keep your receipts!
If you have questions about what can be included when calculating your cost basis, make sure to contact an accountant you can trust.
Do I have to pay capital gains tax on the sale of my California home that I inherited?
Yes, you will have to pay capital gains tax on the profit from selling a California home you inherited. However, the gain will be calculated based on the market value of the home at the time you inherited it.
For example, if your parents purchased a home in 1980 for $100,000, you inherited the home in 2019, and then you sold the home in 2022 for $500,000, you won’t have to pay capital gains tax on $400,000. Instead, if the home’s market value in 2019 was $450,000, then you’d pay capital gains tax on $50,000 ($500,000 – $450,000).
How do I report capital gains on the sale of my home in California?
If you have to pay capital gains tax on the profits from your home’s sale, you’ll report your gains on California’s Schedule D 540. You’ll also report your gains to the IRS using Schedule D.
If you’re expecting to make a large sum of money from selling a home in California, good for you! However, beware that you may pay capital gains on that money. Hopefully you’ll qualify for an exemption, but if you don’t, remember to include home improvements in your cost basis in order to lower the amount you’ll have to pay in taxes.
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