Capital Gains Tax: Federal Rates, California Rates, and the Gap

Federal law taxes long-term capital gains at preferential rates. California does not. The state taxes capital gains as ordinary income, at rates reaching 13.3%, with no distinction between a stock held twenty years and a paycheck earned last week.

That single fact drives most gain planning for California residents. A seller modeling a transaction on the 20% federal rate is understating the real cost by a wide margin, and the combined federal, NIIT, and California burden on a large gain is among the highest in the country.

We advise on gain recognition, entity and timing structure, and examination defense for clients in Temecula, Murrieta, San Diego, Riverside, and San Bernardino.

The 2026 Federal Rates

Long-term rates — assets held more than one year — remain 0%, 15%, and 20%. For 2026, the 0% bracket for a single filer runs to roughly $49,450 of taxable income, and the 20% rate begins near $545,500. Short-term gains on assets held a year or less are taxed at ordinary rates.

Two additional federal layers apply:

• Net investment income tax — 3.8% on the lesser of net investment income or modified AGI above $200,000 single / $250,000 married filing jointly. These thresholds are not indexed, so they capture more taxpayers every year.
• Special rates — 25% on unrecaptured Section 1250 gain from depreciated real estate, and 28% on collectibles and on the non-excluded portion of qualified small business stock gain.

What a California Seller Actually Pays

California’s brackets top out at 12.3%, plus the 1% mental health services tax on income over $1 million, for a 13.3% top marginal rate — applied to capital gains with no preference.

For a high-income California resident recognizing a large long-term gain, the combined rate approaches 37% once the 20% federal rate, the 3.8% NIIT, and the 13.3% state rate are stacked. On a $2 million gain, the difference between modeling 20% and modeling the real combined figure is several hundred thousand dollars.

Practical consequences that follow from this:

• Holding period matters less for California. The federal short-term/long-term distinction is worth a great deal; on the state return it is worth nothing.
• Estimated payments need attention. A large gain creates a California liability that withholding will not cover, and underpayment penalties on gain years are among the most common avoidable costs we see.
• Timing across tax years and installment treatment carry more weight than they would in a no-tax or low-tax state.

Qualified Small Business Stock After OBBBA

Section 1202 is the most valuable capital gains provision in the Code, and OBBBA expanded it substantially for stock issued after July 4, 2025:

• Tiered holding periods — 50% exclusion at three years, 75% at four years, 100% at five years, replacing the previous all-or-nothing five-year cliff
• Per-issuer cap raised from $10 million to $15 million, or ten times basis if greater, with inflation indexing beginning after 2026
• Gross asset ceiling raised from $50 million to $75 million, expanding the range of companies whose stock can qualify

Stock acquired on or before July 4, 2025 stays under the prior rules — five years and a $10 million cap. The tiered exclusions do not apply retroactively, and pre-OBBBA stock generally cannot be converted into the new regime through a reorganization or exchange.

Gain above the cap or outside the exclusion is taxed as Section 1202 gain at a maximum 28% federal rate plus NIIT. And under Section 1045, a holder who has owned QSBS more than six months can roll proceeds into new QSBS within 60 days and tack the holding period — an underused option when a sale comes before the exclusion threshold is met.

The California problem: California does not provide a QSBS exclusion. A founder in San Diego who excludes $15 million federally still reports the entire gain on the California return at ordinary rates. Any model presented as showing tax-free treatment of a QSBS sale is a federal-only model, and for a California resident it is materially incomplete. This is one of the sharpest federal-state divergences in the Code, and it belongs in the conversation before an exit is structured — not after.

Deferral and Reduction Strategies

Section 1031 exchanges. Real property only. California now conforms to the real-property-only limitation for exchanges beginning in 2025. California also imposes a clawback: a resident who exchanges California property for out-of-state replacement property must file an annual information return on FTB Form 3840 for as long as the deferred gain remains outstanding, and California taxes the gain when it is eventually recognized. Exchanging out of California does not escape California tax on the deferred gain.

Opportunity Zones. Gain invested in a qualified opportunity fund within 180 days is deferred, with additional benefits for long holding periods. California does not conform to the federal opportunity zone provisions, so the deferral is federal only.

Installment sales. Spreading gain across years under Section 453 can keep income below the NIIT threshold and out of the top California bracket. It carries counterparty risk and interest charges on larger deferred balances.

Loss harvesting. Capital losses offset capital gains without limit, and $3,000 of ordinary income annually, with indefinite carryforward. Watch the wash sale rule on substantially identical securities.

Charitable strategies. Donating appreciated property held long-term generally yields a fair market value deduction without recognizing gain. Charitable remainder trusts can spread recognition across a term.

Basis step-up. Assets held until death receive a step-up to fair market value under Section 1014, eliminating unrealized appreciation entirely. With the estate tax exemption at $15 million, holding appreciated assets is frequently better than gifting them.

Residency and the Sourcing Question

Moving out of California before a large gain is a strategy people attempt constantly, and the Franchise Tax Board examines it accordingly — residency audits of out-of-state filers rose 126% between 2019 and 2023.

Two things determine the outcome. First, whether residency actually changed before the gain was recognized; California presumes continued residency until domicile is affirmatively changed, and applies a closest-connections analysis. Second, whether the gain is California-source regardless of residency — gain on California real property is taxed by California whether you live here or not, as is gain attributable to a California business.

Selling a business in the year of a move is the single most reliably audited fact pattern in California tax practice. It can be done correctly. It cannot be done casually.

Frequently Asked Questions

Does California have a lower rate for long-term capital gains?

No. California taxes capital gains as ordinary income at rates up to 13.3%. There is no state preferential rate and no benefit to holding period on the California return.

What is the combined tax rate on a large gain for a California resident?

Approaching 37% at the top — 20% federal, 3.8% NIIT, and 13.3% California. The exact figure depends on total income and deductions.

Does California follow the QSBS exclusion?

No. California provides no QSBS exclusion, so gain excluded federally under Section 1202 is still fully taxable by California.

Can I avoid California tax by moving before I sell?

Only if residency genuinely changed before recognition, and only for gain that is not California-source. Gain on California real property is taxed regardless of residency, and the FTB audits departure-year sales closely.

Does a 1031 exchange work in California?

Yes, for real property. But exchanging into out-of-state replacement property requires annual FTB Form 3840 reporting, and California taxes the deferred gain when it is eventually recognized.

What is the net investment income tax?

3.8% on the lesser of net investment income or MAGI above $200,000 single / $250,000 joint. The thresholds are not inflation-indexed.

How does depreciation affect the tax on a rental property sale?

Depreciation taken reduces basis and increases gain, and unrecaptured Section 1250 gain is taxed federally at up to 25% — higher than the 20% long-term rate. California taxes the whole amount at ordinary rates. See taxes on home sales.

How do capital losses carry forward?

Capital losses offset capital gains without limit, and up to $3,000 of ordinary income each year. Unused losses carry forward indefinitely for federal purposes, and California follows the same basic structure — a large loss year can shelter gains for many years afterward.

What is the holding period and when does it start?

More than one year qualifies for long-term federal rates. The period generally begins the day after acquisition. Inherited property is automatically treated as long-term regardless of how briefly the heir held it, and gifted property tacks the donor’s holding period.

Model the Transaction Before You Close

Capital gains planning has a hard boundary: once the sale closes, the options are largely gone. Entity structure, installment terms, exchange mechanics, charitable components, and residency questions all have to be settled beforehand.

Pietro Canestrelli holds an LL.M. in Taxation and advises on gain planning, QSBS qualification, exchange and installment structures, and California residency and sourcing. Schedule a consultation, or review our tax planning and business sale services.