Taxes are a necessity in modern American society. They pay for basic infrastructures, like roads and schools, and they go toward the salaries of teachers, post office workers, and other government employees.
While everyone with a job has to pay income taxes, those who own property have to pay additional taxes – it comes with the benefits of owning a home. This can become even more complicated if you are selling your home in California, thanks to California’s home sale tax. Navigating the various California taxes on home sale can be intimidating, and filing these taxes improperly can potentially lead to you overpaying or getting a visit from the IRS later on.
Read our guide on the taxes that you have to pay when selling a home in California.
The capital gains tax is one of the primary taxes associated with selling a property in California. Since it is a priority, we’ll be spending the majority of our time covering capital gains in more detail. To summarize, capital gains refer to the increase in the assessed value of an asset, such as real estate, that is realized upon its sale. When you sell your home for more than the initial purchase price, that difference is the capital gain and that is what is subject to taxation.
In addition to capital gains tax, you should considerproperty tax implications if you are planning to sell your house. Property tax is an ad valorem tax, meaning it is based on the assessed value of the property. California’s property tax system, governed by Proposition 13, limits property tax rates to 1% of the assessed value at the time of purchase, with annual increases limited to 2%.
In some cases, cities or counties may impose a transfer tax on the sale of real estate properties. The transfer tax rate varies depending on the location and the property’s value. For example, in San Francisco, the transfer tax rate is $3.30 for every $1,000 of the property’s sales price.
Selling a home can come with plenty of confusing steps and headaches, which is why it can be so rewarding to get such a high price for your home. However, the IRS will get involved in almost any sort of financial transaction, and that includes selling a home.
Capital gains refers to an increase in an asset’s assessed value and is realized when you sell that asset. This generally comprises stocks and funds, which inherently have prices that fluctuate widely, but tangible assets, like boats, cars, and real estate, can also fall under the umbrella. Essentially, if you sell your home for more than your initial purchase price, that difference is the capital gain, and you will have to pay taxes for it.
The opposite of a capital gain is a capital loss (in other words, if you sell a property for less than the original property price). A capital loss must be reported to the IRS, and you may be able to deduct your losses up to a certain limit.
The taxes on capital gains and sold property will vary from state to state. As mentioned, capital gains taxes are assessed based on the difference between what you initially paid for your home (also known as your basis) and what you sell the home for. This means you only get taxed on that difference of market value, not on the total amount that you sold your home for. You may be taxed for your capital gain at both state and federal levels.
Based on the Taxpayer Relief Act of 1997, the IRS allows you to exclude the first $250,000 that you make when you sell your home if you are single. If you are married and filing joint taxes, the exemption goes up to $500,000. This essentially removes your profit from your taxable income. For example, if you bought a home for $300,000 and you are now selling it for $900,000, you made $600,000 on the sale. If you are married and filing jointly, you would be exempt from paying for the first $500,000 of that amount, though that still means that you may be taxed on the remaining $100,000.
However, in order for this exemption to apply, the property must be considered your primary residence based on the rules of the IRS. By the IRS’s definition, a home can be considered a primary or principal residence if you have lived in it for two of the last five years. The two years do not have to be consecutive. For example, say you bought a condo and lived in it for one year. You then rented the condo out for a year, your tenant moves out at the end of their lease, and you move back in for a year. You will still gain the tax return exemption on that condo.
Another wrinkle to the tax exemption: you can only take advantage of the exemption once every two years. This means that if you sold two houses that could both be considered a primary residence, you wouldn’t be able to sell both tax free. This also prevents people from taking tax exemptions if they are constantly moving and selling homes. There are, of course, nuances to every situation, so it is highly advised that you speak with a tax expert to determine the exact steps that you can or need to take.
Your tax exclusion is also rendered unusable if:
On the other hand, you may qualify for the tax exemption if:
The five-year period may also extend up to ten years if you or your spouse has served “qualified official extended duty” in the military, foreign service, or federal intelligence agencies.
If all or part of the money you earned from a home sale is taxable, you will have to pay based on the capital gains tax rates. Short-term capital gains tax rates apply if the property owner owned the property for a year or less. The rate is equivalent to your regular income tax rate, better known as your tax bracket. There are seven tax brackets that vary your tax rate based on the amount of money that you made in any given year.
Long-term capital gains tax rates apply to properties that you have owned for more than one year. These rates are much less burdensome than short-term capital gains rates. Many people actually qualify for a 0 percent tax rate here. Others may pay 15 to 20 percent based on your income and filing status.
Let’s look at an example to help understand capital gains and different tax rates. Imagine you bought a property for $500,000, owned it for three years and then sold it for $800,000. Your cost basis would be $500,000 and the capital gain would be $300,000. If you are subject to long-term capital gains tax and your tax rate is 15%, your capital gains tax liability would be $45,000 (15% of $300,000).
The Primary Residence Exemption is one of the most significant tax exemptions available to homeowners in California. Following the Taxpayer Relief Act of 1997, if you are single, you can exclude up to $250,000 in capital gains when selling your primary residence. If you are married and filing jointly, the exemption increases to $500,000.
To qualify for the Primary Residence Exemption, the following conditions must be met:
The property must have been your primary residence for at least two out of the last five years before the sale.
The two years of residence do not have to be consecutive. This means that short-term absences, such as renting out the property or staying elsewhere, don’t affect he primary residence status.
You can take advantage of this exemption once every two years.
If you are married and filing jointly, at least one spouse must meet the residency requirement.The exemption may extend up to ten years if you or your spouse served in the military, foreign service, or federal intelligence agencies for an extended period.
There are a wide range of strategies involved with reducing or even potentially avoiding property sales tax in California. Start by considering partial exemptions wherein people may not qualify for the full exemption. Partial exemptions are allowed for a wide range of reasons, including:
Homeowners can also gain exemptions if they transfer to a nursing home. In this case, the ownership duration is reduced from two years to just one year, and the residency in the nursing home is added to the ownership time of the initial property.
A partial exemption allows you to exclude some of the taxable gain, even if you do not fully qualify for a full exemption. “Unforeseeable events,” like those listed above, tend to be the most common reason for allowed partial exemptions. Talk to a professional accountant for more information on your specific situation.
A good way for a homeowner to avoid or reduce the capital gains tax is to simply live in the house for at least two years. This becomes even more important considering how expensive short-term capital gains taxes are compared to long-term capital gains. This can be even more burdensome for house flippers.
Keep any receipts of home improvements. While the initial amount that you paid for the house takes up much of the amount of the cost basis, any improvements you make over the years, even after your move-in date, can still be added to that basis. This can significantly reduce the actual difference between the basis and the sale price, which can then lower the capital gains. This includes:
There are other expenses that you can add into your basis on top of home improvements. Any purchase expenses, like closing costs, settlement fees, and title insurance, can be added to the cost basis. You can go even further by adding any selling costs that you may have incurred to get your house on the market. This includes attorney fees, transfer taxes, and real estate agent commissions (to reap the benefits of working with a real estate agent). By adding up the buying and selling costs and the improvements you made on your property, your capital gain may actually be much less than what you initially expected, allowing you to easily qualify for the tax exemptions.
The taxes on selling a home can be confusing and hard to manage on your own. This is why many homeowners put off selling their homes or choose instead to rent their homes out. However, if you are looking to relocate, consult Berkshire Hathaway HomeServices California Properties. Our team of Southern California real estate agents can guide you through the process of putting your home on the market and closing on a deal that is profitable and beneficial for all parties involved.