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How are capital gains taxed on a rental property in California?
In two layers. Federally, the slice of your gain that equals the depreciation you took is taxed at up to 25 percent, and the rest at 15 or 20 percent, usually plus the 3.8 percent surtax. California then taxes the whole gain as ordinary income, up to 13.3 percent, and escrow withholds 3 1/3 percent of the sale price before you see a check.
A rental is taxed on the gain, and depreciation makes the gain bigger than you think.
Start with what you sell it for. Take off the costs of selling, like the commission and escrow fees. Then take off your adjusted basis: what you paid, plus improvements, minus every dollar of depreciation you took while you owned it.
That last part is the trap. Depreciation gave you a deduction every year. It also lowered your basis by the same amount, so the gain grows by every dollar you deducted. A building bought for 600,000 twenty years ago may carry a basis closer to 300,000 today.
Quick note on who is talking. opfinances.com is a licensed insurance agency. We are not a financial advisor, not a fiduciary, and not a tax adviser. This is general education, not advice about your property.
The depreciation comes back at up to 25 percent, whether you claimed it or not.
Federal law splits your gain in two. The slice equal to the depreciation you took on the building is called unrecaptured section 1250 gain, and it is taxed at your ordinary rate up to a 25 percent cap. It catches most landlords off guard.
The rule runs on depreciation allowed or allowable. If you never depreciated the building, or your preparer missed it, the IRS still taxes you as if you had, so you get the recapture without ever getting the deduction. If that sounds like you, ask a tax professional about catching up the missed depreciation before you sell.
The rest of the gain gets the long term rate, and the 3.8 percent surtax usually comes along.
If you owned it more than a year, the gain above the depreciation slice is a long term capital gain: 15 percent for most sellers, and 20 percent on the part that pushes your income past the top threshold. The sale itself usually does the pushing.
Then there is the 3.8 percent net investment income tax. It applies once your income for the year passes 200,000 for a single filer or 250,000 for a married couple, and a rental sale counts. Most landlords pay it on the whole gain, recapture included. Real estate professionals can be exempt, but the tests are strict.
California taxes all of it like wages, and escrow takes a deposit before you see the check.
California has no capital gains rate. The whole gain, depreciation slice and all, gets added to your other income and taxed at the ordinary brackets, which climb to 12.3 percent, plus 1 percent on income over 1,000,000. The federal 25 percent cap means nothing here.
Escrow is generally required to withhold 3 1/3 percent of the gross sale price and send it to the Franchise Tax Board, unless an exemption applies. On a 1,600,000 sale that is about 53,000 out of your proceeds at closing. It is a prepayment credited on your return, not an extra tax. You can elect to have it figured on your estimated gain instead, but only before closing.
Old losses you could never use may come back in the year you sell.
Many landlords show a paper loss most years after depreciation and never get to deduct it. The passive activity rules limit how much rental loss can offset wages, and the rest piles up as suspended losses, year after year.
A full sale to an unrelated buyer, in a taxable deal, releases them. They offset the gain on the sale and then your other income that year. A preparer who does not dig through your old returns will miss it. Ask for the number before you set a price in your head.
A long held Bay Area rental can owe about a third of its gain, and the time to question that is before escrow.
Illustrative arithmetic, not a tax estimate. A married couple bought a San Jose duplex for 600,000, put in 50,000 of improvements, and took about 340,000 of depreciation over the years. Their adjusted basis is around 310,000. They sell for 1,600,000 with 80,000 of selling costs, so the gain is about 1,210,000.
Federally, the 340,000 depreciation slice is taxed at up to 25 percent, about 85,000. The remaining 870,000 is taxed at 15 and 20 percent, roughly 165,000 with about 100,000 of other income that year. The 3.8 percent surtax adds about 40,000. Call it 290,000 federal. California adds roughly 125,000 more. Together that is about 415,000, around a third of the gain, and escrow already sent about 53,000 of it to Sacramento at closing.
Your numbers will be different. Brackets, other income and suspended losses all move the answer.
That 415,000 is the default. There are structures that can change the timing or the size of the bill, and nearly all of them have to exist before the purchase agreement is binding. Sign first and most of them are gone. We are not going to list them here. Which ones fit depends on facts only you have, and sometimes the honest answer is that the default is fine.
One more thing about incentives. We are paid when a client ends up in a product we offer. Nobody is paid when the answer is that you should just pay the tax. Weigh anything anyone tells you about your sale with that in mind, us included.
Before you decide
Questions worth asking.
How much depreciation have I actually taken on this property, and what would the IRS say was allowable, since the recapture runs on the allowable number?
How much of my gain is unrecaptured section 1250 gain at up to 25 percent, and how much gets the 15 or 20 percent rate?
Will the 3.8 percent surtax apply to me, and what will the sale do to my federal and California brackets in that year?
Do I have suspended passive losses on my old returns, and how much of the gain do they wipe out?
How much will escrow withhold for California, and should we elect the withholding based on my estimated gain instead of 3 1/3 percent of the price?
Is there anything that has to be decided before I sign the purchase agreement? And if you are recommending something that changes the tax, what does it cost, how are you paid on it, and what happens if I do nothing?
Related
Do I pay depreciation recapture if I never claimed depreciation?
Yes. The rule is based on depreciation allowed or allowable, so the IRS treats the building as depreciated even if you skipped it. Before selling, ask a tax professional about catching up the missed deductions, because there is a procedure for that.
Does California tax depreciation recapture at 25 percent?
No. California has no special rate for any part of the gain. The recapture and the rest of the gain are added to your other income and taxed at the ordinary brackets, up to 13.3 percent.
How much does escrow withhold when I sell a rental in California?
Generally 3 1/3 percent of the gross sale price, sent to the Franchise Tax Board, unless an exemption applies. You can elect withholding based on your estimated gain instead. Either way it is a prepayment that is credited on your California return.
Can I move into my rental and use the home sale exclusion?
Partly. Once you have lived there two of the last five years it can qualify, but depreciation taken after May 1997 is still recaptured, and the years it was a rental after 2008 count as nonqualified use, which cuts the exclusion in proportion.
What happens to the tax if I keep the rental until I die?
Under current law your heirs generally receive the property at its value on the date of death, so the gain and the depreciation recapture that built up during your life are not taxed when they sell. Estate tax is a separate question, and the law can change.
Where this fits.
This question sits inside a bigger one. Tax Deferred Strategies walks through the whole decision rather than this one piece of it.
On Point Finances is a licensed insurance agency, not a tax, legal, or investment adviser. This page is general education, not a recommendation, and reading it does not create a client relationship.