Taxes on Home Sales in California

The Section 121 exclusion lets most homeowners exclude $250,000 of gain — $500,000 for a married couple filing jointly — on the sale of a principal residence. Those figures are unchanged for 2026 and, unlike most of the Code, have never been indexed for inflation. They were set in 1997.

That last point is the whole problem in Southern California. A couple who bought in Temecula or coastal San Diego two decades ago can easily have gain exceeding $500,000, and everything above the exclusion is taxable — federally at capital gains rates, and by California at ordinary rates reaching 13.3%.

We advise sellers, landlords, and families handling inherited property throughout Temecula, Murrieta, San Diego, Riverside, and San Bernardino.

Qualifying for the Exclusion

Three tests must be met:

• Ownership — you owned the home at least two of the five years before the sale
• Use — it was your principal residence for at least two of those same five years; the periods need not be continuous or concurrent
• Frequency — you have not excluded gain on another home sale within the two years before this one

For married couples claiming $500,000, either spouse can meet the ownership test, but both must meet the use test, and neither may have used the exclusion within two years.

A partial exclusion is available even when the two-year tests are not met, if the sale was primarily due to a change in place of employment, health, or unforeseen circumstances. The exclusion is prorated by the fraction of the two-year period satisfied — a couple who lived in the home twelve months before an out-of-area job transfer can exclude up to $250,000 rather than nothing. This is one of the most commonly missed provisions in residential sales.

Calculating the Gain

Gain is not the difference between what you paid and what you sold for. It is amount realized less adjusted basis, and both sides are adjustable.

Amount realized — sale price less commissions, escrow and title fees, transfer taxes, and other selling costs.

Adjusted basis — original purchase price, plus closing costs at acquisition, plus capital improvements, less any depreciation taken.

Capital improvements are where most under-reported basis lives. Room additions, roof replacement, HVAC systems, kitchen and bath remodels, new windows, landscaping and hardscape, solar installation, pools, and permanent fixtures all add to basis. Ordinary repairs and maintenance do not — a repaired roof is a repair; a replaced roof is an improvement.

Over twenty or thirty years of ownership, documented improvements frequently total six figures and can move a taxable sale back under the exclusion entirely. Records are the constraint, which is why we tell clients to keep improvement receipts for as long as they own the property, not for the usual retention period.

Depreciation Recapture

Any depreciation taken after May 6, 1997 — for a rental period or a home office — cannot be excluded under Section 121. It must be recognized as unrecaptured Section 1250 gain, taxed federally at up to 25%.

Two traps follow. First, recapture applies to depreciation allowed or allowable — meaning it applies even if you never actually claimed it. A landlord who failed to depreciate still faces recapture on the amount that could have been taken. Second, converting a rental to a personal residence does not erase the earlier depreciation, and periods of nonqualified use after 2008 reduce the excludable portion proportionally.

California taxes recapture at ordinary rates along with everything else, with no 25% ceiling.

California-Specific Issues

Withholding at Closing

California requires real estate withholding at closing on most sales — generally 3⅓% of the total sale price, or an elective alternative computed on the gain, reported on FTB Form 593.

Note the base: withholding is on the sale price, not the gain. On a $900,000 sale, that is roughly $30,000 withheld even where the gain is fully excluded under Section 121. Exemptions exist — including for a principal residence qualifying under Section 121 — but they must be certified on Form 593 at closing. Sellers who do not certify have the money withheld and must wait until they file a California return to recover it.

This is entirely avoidable and happens constantly. Raise it with the escrow officer before signing.

Property Tax and Proposition 19

Prop 19 affects the buyer side and the inheritance side rather than the sale itself, but it belongs in the same conversation.

Homeowners who are 55 or older, severely disabled, or victims of a wildfire or natural disaster may transfer their existing assessed value to a replacement principal residence anywhere in California, up to three times. For a long-held property with a low assessed value, this is often worth more than any income tax planning available on the sale — and it is a reason to sequence the purchase and sale deliberately.

On the inheritance side, Prop 19 sharply narrowed the parent-child exclusion. Inherited property that the child does not occupy as a principal residence is reassessed to market value. See our estate tax page.

Inherited Property and Basis

Property acquired from a decedent receives a step-up in basis to fair market value at the date of death under Section 1014. An heir who sells shortly after death typically has little or no gain, regardless of what the decedent originally paid.

California is a community property state, which produces a meaningful advantage: on the death of one spouse, both halves of community property generally receive a step-up, not just the decedent’s half. In a separate property state, only the decedent’s half steps up. For a couple holding decades of California appreciation, this difference is substantial — and it is a reason to confirm how title is actually held well before it matters.

Selling a Rental or Second Home

Section 121 does not apply to property that was not your principal residence. Options for investment property include:

• Section 1031 exchange — deferral into replacement real property; note that California requires annual Form 3840 reporting when exchanging into out-of-state property, and taxes the deferred gain when recognized
• Installment sale — spreading gain across years to manage bracket and NIIT exposure
• Conversion to a principal residence — a partial exclusion may become available after two years of qualifying use, subject to nonqualified use allocation and depreciation recapture

Our capital gains page covers these in more depth.

Frequently Asked Questions

How much home sale gain is tax-free?

$250,000 single, $500,000 married filing jointly, if the ownership, use, and frequency tests are met. The figures are not inflation-indexed and have been unchanged since 1997.

Do I owe California tax if the gain is excluded federally?

California conforms to the Section 121 exclusion, so an excluded gain is generally excluded for California too. Any gain above the exclusion is taxed at ordinary California rates up to 13.3%.

Why is money being withheld at my closing?

California real estate withholding — generally 3⅓% of the sale price. A principal residence qualifying under Section 121 can be exempt, but the exemption must be certified on FTB Form 593 at closing.

Can I still exclude gain if I lived there less than two years?

Possibly, through the partial exclusion, if the sale was due to a change in employment, health, or unforeseen circumstances. The exclusion is prorated by the portion of the two years satisfied.

I rented the house out for a few years. Does that matter?

Yes. Depreciation allowed or allowable is recaptured at up to 25% federally and cannot be excluded, and nonqualified use periods after 2008 reduce the excludable share proportionally.

What happens when I inherit a house and sell it?

Basis steps up to fair market value at date of death, so a prompt sale usually produces little gain. Property tax is a separate question — under Prop 19, reassessment generally follows unless you occupy it as your principal residence.

Can I keep my low property tax if I move?

If you are 55 or older, severely disabled, or a disaster victim, Prop 19 allows transferring your assessed value to a replacement principal residence anywhere in California, up to three times.

Does a divorce affect the home sale exclusion?

Transfers between spouses incident to divorce are generally nontaxable, and a spouse who remains in the home under a divorce instrument can sometimes be credited with the other spouse’s use. The $500,000 joint exclusion generally requires filing jointly for the year of sale, so timing relative to the divorce matters.

What if I own the home with someone who is not my spouse?

Each owner applies the exclusion separately to their own share of the gain, and each must independently satisfy the ownership and use tests. Two unmarried co-owners who both qualify can each exclude up to $250,000 of their respective gain.

Get the Numbers Before Escrow Closes

Most of what determines the tax on a home sale is fixed before closing: how title is held, whether improvements are documented, whether the Form 593 exemption gets certified, and whether a Prop 19 base-year transfer is being coordinated with the purchase. Afterward, the options narrow considerably.

Pietro Canestrelli holds an LL.M. in Taxation and advises on residential and investment property sales, exchange structures, depreciation recapture, and California withholding and property tax issues. Schedule a consultation, or review our tax planning services.