Selling or buying a property in the country’s most competitive real estate market is no easy feat, but when you start taking taxes into account, the process of selling your California home can quickly become an incredibly expensive feat!
Now, no matter how steep tax rates might be at the moment, you should keep in mind that there’s no way you can cut corners or avoid paying taxes when selling a property.
Being well-read and updated on the ins and outs of California’s tax law is a fundamental first step when selling a home, and your real estate agent or real estate lawyer will usually be the first person to talk you through all the legal aspects of the transaction before you list your property.
But what if you decide to sell your home without a local real estate broker to oversee the process?
How can you make sure you’re not only paying the tax bill you owe but also taking advantage of the system in a way that will dramatically reduce your tax bill, 100% legally?
Here’s all you need to know about capital gains taxes and property taxes in California before you go ahead with the sale of your home, including a few tips on how to make the most out of capital gains exemption!
The Capital Gains Tax in California
First things first, let’s have a quick look at how capital gains tax works.
Capital gains are defined as the total profit derived from the sale of a capital asset, such as a business, land, stocks, and (in some cases) real estate. In terms of how to report them, capital gains are usually registered as taxable income and treated as such, unless they are considered long-term capital gains.
Long-term capital gains are profits derived from the sale of an investment that has been owned for over 12 months at the time of the transaction. They are given a more favorable treatment compared to short-term capital gains, which instead are assets and investments the seller has owned for less than a year.
In this case, favorable treatment means much lower tax rates: Sellers will usually owe either 18% or 28% depending on their income and marital status, with a tax exemption (zero rate) available for a few selected taxpayer categories.
For example, up to $250,000 of capital gains from the sale of principal residences (and $500,000 for married couples) is tax-free if you have lived in the house for at least 2 of the previous 5 years.
You can also be exempt from paying capital gain tax on your sale if you serve in the military, work for the intelligence community, or have a disability.
How to Figure Out Your Capital Gain
Now, if you want to calculate your capital gain or capital loss to figure out how much capital gains tax you owe (and what you can take out!), you’re going to need proof of the purchase price of the property, the current purchase price, the commissions paid when you first bought the home, and the total cost of all home improvements made.
Once you’ve gathered all the receipts, the formula is pretty simple: Subtract the original price, commissions, and home improvements from the current purchase price, and then subtract the amount you can be exempted (in most cases, $500,000) from the total.
What you’ll have is the capital gains tax you owe!
Once you’ve taken care of capital gains taxes, you’ll also have to think about any property taxes paid in advance as well as property taxes due in escrow.
This is one of the most important things to keep in mind when you’re figuring out closing costs with the buyer. You should make sure to negotiate who will pay what and when with the buyer and lender well before the closing date!
Generally speaking, the seller will pay prorated property taxes for the time they have lived in the property since the beginning of the new tax year, while the buyer will pay the prorated amount for the rest of the year.
In case you have already paid property taxes in advance, you can negotiate with the buyer and get the prorated amount credited back to you — taking the hassle out of paying property taxes!
Transfer tax doesn’t get as much exposure as capital gains taxes or property tax when it comes to the costs of selling a property, mostly because not all states and cities charge it.
This tax is usually another part of the closing costs shared by seller and buyer, and it’s based on the value of the property and its classification. In most cases, the seller is the party liable for paying transfer tax, but both parties can come to an agreement if the seller is eligible for transfer tax exemption or is unable to pay.
In California, transfer taxes can be quite expensive: You’ll likely end up paying taxes to three different bodies (state, county, and city) as well as a smaller HOA transfer fee.
So, exactly how much tax will you end up paying?
State transfer tax in California works out at $0.55 for every $500 of the property’s value, while rates for county taxes will vary greatly depending on the location. If you live in Los Angeles county, for example, you’ll end up paying double compared to residents of other counties, with a tax rate of $1.10 per $1000 of property value.
Finally, we have city transfer taxes: Just like county tax, they will vary greatly depending on your location as well as on the value of the property. City transfer tax can be as little as $2 per $1000 value or upwards of $5 per $1000, even if the two locations are merely a one-hour drive away, so you should make sure to check with your municipality to get the correct figure for the current tax year.
On top of that, some Californian cities like San Francisco operate their city transfer fee on a tier-based system, which takes into account the value of your home to apply a fixed fee.
Keep in mind that in some cities in Northern California buyers can be the ones liable for paying transfer tax, so once again, make sure to check your local legislation before you start any negotiations!
Is It True That You Can Sell Your Home And Not Pay Capital Gains Tax?
As we said at the beginning of this article, there’s no cutting corners when it comes to paying taxes, especially in a state like California where closing costs end up being as high as 8% or even 10% of the sale price.
But that doesn’t mean that you can’t use local laws in your favor and take advantage of exemptions if you’re eligible!
Capital gains tax will often end up being the most expensive fee you’ll have to pay as a seller. While there’s no way around paying capital gains as taxable income, if you have owned the property for less than a year, you’ll find that in many cases sellers can get out of paying capital gains tax.
Well, there are several ways you can become eligible for capital gains tax exclusion even if you don’t immediately qualify — here are some of the most popular methods:
How to Avoid Capital Gains Tax on Home Sales
First things first, let’s go over the key rules for capital gains tax exemption once more.
If you’re single, you can sell your primary residence and not pay taxes for the first $250,000 of the sale, or the first $500,000 if you’re married and filing jointly.
In order to qualify, the property must be your primary residence according to IRS records, meaning that there’s proof you’ve been living in the property for at least two of the last five years.
If you have not been living in the property for at least two years or you’ve bought the house as an investment property to sell a year later, you won’t be able to claim any tax write-off and you’ll owe tax for what’s called a short-term capital gain. This is taxed as ordinary income with rates as high as 37%.
So, how can you fit the criteria and enjoy the lower tax rates?
Use 1031 Exchanges to Avoid Taxes
The first way you could be able to avoid paying tax for short-term capital gains is by investing the profit you’ve made from the sale into another property.
This is called a 1031 exchange, and it works like this: You can defer, rather than completely cancel, the tax owed by virtually “exchanging” your property with a similar property.
This is a popular route for real estate investors and companies, as it allows you to grow your investment while deferring taxes, and there’s no limit when it comes to the number of times you can make the swap. In order to be eligible for a 1031 exchange, the new property must be a like-kind property, meaning that the nature (rather than type!) of the new property must be the same as the one you’re selling.
This means that you won’t only be able to exchange an apartment in California for another apartment in California, but you’ll also be able to swap a real estate property for land, as long as it’s in the United States.
The swap is generally only accessible to investors and businesses, but there are ways you can take advantage of the clause as a residential homeowner if you’re selling a vacation home or a second home.
Convert Your Second Home into Your Primary Residence
You can also take advantage of the long-term capital gains tax rate if you convert your second home or rental property into your primary home, as long as you start using it as your residence two years prior to the sale.
This way, you’ll be able to enjoy a more favorable tax rate and get the first $250,000 or $500,000 from the sale of your property tax-free.
In order to convert your rental or second home into your homestead, California law requires you to have proof of principal residence for at least two years, such as voter registration, driver’s license address, or in some cases even a simple utility bill.
Needless to say, this method requires a little bit of thinking ahead, so it might be out of your grasp if you have to sell quickly!
How Installment Sales Lower Taxes
Finally, you can lower capital gains taxes on a second home or rental property by choosing an installment sale option, allowing you to defer part of the capital gains owed over a set term.
Installment sales will set out payments over time consisting of principal (non-taxable), gain, and interest (taxable as income), and you’ll be able to pay lower rates compared to what you would pay on a lump-sum capital gain.
In terms of the amount you’ll pay, you will be taxed in the same way you would have without installments: According to the duration of your ownership (long-term vs short-term).
Do You Really Need a Real Estate Agency to Help Sell Your Home?
Already overwhelmed by the paperwork?
It can be tempting to enlist the help of real estate agents and expensive lawyers to take care of all the complex tax business for you, so you just have to sign on the dotted line and pay closing costs as instructed.
But if you’re looking to sell as quickly as possible and without any of the headaches of listing your property, finding the right agent, and negotiating who will pay for what, there’s no better option than getting in touch with a buyer who understands your troubles!
We buy houses in any condition in Southern California, fast and for cash, requiring only one quick viewing before making you an obligation-free offer.
We will also take care of all closing costs, so you don’t have to pay taxes for the transfer of the property and walk away with cash in hand in a matter of weeks.
Frequently Asked Questions (FAQs)
1. Can I qualify for capital gains tax exemption if I’ve rented out my property at some point?
Yes, you can still qualify, but you must have used the property as your primary residence for at least two of the five years preceding the sale.
2. Are there any tax implications if I sell a property I inherited in California?
Yes, the sale of an inherited property can have capital gains tax implications, but these are often based on the property’s value at the time of inheritance rather than the original purchase price.
3. What is the difference between short-term and long-term capital gains tax rates?
Short-term capital gains are taxed as ordinary income, while long-term capital gains, on assets held for more than a year, typically have lower tax rates.
4. Can improvements made to the property reduce my capital gains tax?
Yes, the cost of improvements can be added to the property’s original purchase price, potentially reducing the taxable capital gain.
5. Is it mandatory to reinvest the profits from a home sale to avoid capital gains tax?
No, it’s not mandatory. The exemption applies to a certain amount ($250,000 for singles, $500,000 for married couples) without the need to reinvest.
6. How does divorce or separation affect capital gains tax when selling a home in California?
In case of divorce, each individual can qualify for up to $250,000 of capital gains exemption, but specific conditions apply.
7. What happens if I sell my California property at a loss?
If you sell your property at a loss, you generally do not owe capital gains tax, and the loss can sometimes be used to offset other capital gains.
Navigating the complexities of California’s real estate tax laws can be challenging, but with the right knowledge and strategies, you can effectively manage your taxes when selling your home. Understanding capital gains taxes, property taxes, and available exemptions can lead to a more financially advantageous sale.
California, the Golden State, is a blend of rich history, diverse culture, economic dynamism, and natural beauty. From its gold rush legacy to the tech boom, and from its scenic coastlines to iconic landmarks, California offers a unique and vibrant experience for both residents and visitors.