The California Capital-Gains Tax Trap: What Real Estate Investors Aren’t Told (2025 Update)
Most real estate investors believe they’ll only pay the 20% federal capital gains rate—until they sell, and California’s tax bill wipes out a huge chunk of their profit. That shock hits everyone from first-time flippers to veteran landlords. For 2025, California’s approach remains aggressive, catching many by surprise and threatening to turn lucrative sales into regretful ones.
This guide strips away the confusion about the California capital-gains tax for real estate investors. We’ll expose what the FTB doesn’t publicize, break down the true numbers, and detail the strategies sophisticated investors use to minimize their losses—legally.
This information is current as of 7/24/2025. Tax laws change frequently. If you’re reading this later, check for updates from the Franchise Tax Board or IRS.
The Fast Answer: California Capital-Gains Tax Is Ordinary Income (Not 20%)
Many believe real estate gains—especially on long-held investments—enjoy a lower, special rate in California. Not so. California capital-gains tax applies your full state income tax rate, whether you held the property for five months or five years. For 2025, that rate runs from 1% up to 13.3%, hitting high-income investors the hardest.
- Federal capital gains tax (long term, 2025): 0%, 15%, or 20% (most investors pay 15–20%)
- Additional federal taxes: Net Investment Income Tax (NIIT) of 3.8% for higher earners
- California capital-gains tax: Your marginal income tax rate—up to 13.3%
Quick Example—$1M Gain:
• Federal LTCG tax: $200,000
• NIIT (3.8%): $38,000
• California (13.3%): $133,000
• Total tax: $371,000 — over a third of your gain gone before deductions.
How California Calculates Real Estate Capital Gains (2025 Rules)
The math starts simple but gets complicated fast. Calculate your gain as:
Capital gain = Sales price – adjusted basis – selling expenses
- Your adjusted basis includes the purchase price plus improvements, minus depreciation (important for landlords and flippers).
- California recognizes all your gain—no discounted rate for ‘long-term’ holdings.
- Past depreciation deductions (even those taken under federal bonus rules) are “recaptured” and taxed at your regular income rate by CA.
Scenario: Sell a Rental for $800,000 with $300,000 Gain
If you’re in the 13.3% CA bracket:
• CA tax: $39,900
If you had $100,000 in depreciation over the years, CA also taxes that as ordinary income.
• Extra CA tax: $13,300
Total CA state tax: $53,200
The myth that only “big” sellers or corporations are affected is false; anyone with property appreciation faces this—whether on a single ADU sale or a large multifamily flip.
Federal vs. California: The Real Cost for Property Sales
Federal law offers a “long-term capital gains rate” (typically 15-20%) for assets you hold more than a year. But California ignores this, sticking to your highest state tax bracket. That’s why even accidental landlords feel the sting on modest profits.
| Gain | Fed Tax (20%) | NIIT (3.8%) | CA Tax (13.3%) | Total Tax |
|---|---|---|---|---|
| $200,000 | $40,000 | $7,600 | $26,600 | $74,200 |
| $1,000,000 | $200,000 | $38,000 | $133,000 | $371,000 |
| $5,000,000 | $1,000,000 | $190,000 | $665,000 | $1,855,000 |
High-income investors also may lose out if they previously “accelerated” depreciation for federal taxes—because California’s recapture rules are stricter. Flippers repeating this mistake may face audit flags, triggering scrutiny from the FTB via Form 593.
Pro Tip: Reinvestment May Delay, Not Eliminate, CA Capital Gains Tax
Strategies like 1031 exchanges and installment sales are powerful but must be used correctly under 2025 rules.
1031 Exchange: Allows real estate investors to defer paying capital gains on a sale by rolling proceeds into a “like-kind” property. CA follows federal rules but wants to track deferred gains—partial exchanges or paperwork errors land many in audit trouble.
- Deadlines: Rigid—45 days to identify a replacement; 180 days to close.
- Non-CA replacement: You can defer gains, but CA may “chase” you if you leave the state (see FTB Form 3840).
- Death, divorce, ownership splits? All can trigger immediate CA tax due if not perfectly planned.
Installment Sale: Selling with payments over years lets you spread out gain—sometimes easing bracket creep or the 3.8% NIIT impact. But don’t confuse this with “eliminating” gains—the FTB gets their share as payments come in, and acceleration events (buyer defaults, notes sold) may force tax at once.
Find additional strategies inside our advanced estate & legacy planning guide.
Myth Buster: Living Trusts Don’t Dodge California Gains Taxes
One of the most expensive mistakes we see: believing a revocable trust, will, or bare LLC structure will shield real estate profits from the California capital-gains tax. In reality:
- A standard living trust does not change the tax nature of property sales for CA or federal returns.
- Neither does holding rentals in a personal LLC—unless you use advanced strategies like entity layering or specialized legacy planning (see our entity structuring service).
- Only a bona fide charitable trust or complex partnership may shift or defer gains, and both require specialized set-up well in advance.
Don’t fall for the “just put it in a trust” myth—this lands more clients in multi-year FTB audits than nearly any other misstep.
The Danger Zone: Depreciation Recapture and “Double Taxation” Fears
CA investors often panic when told they owe tax on depreciation “recapture”—the process by which all previous deductions are taxed as regular income (not capital gains) at sale. This is not double taxation; it’s catch-up for earlier tax savings, and the rules differ between IRS and FTB.
- Federal: Recaptured at 25% for most non-corporate sellers.
- California: All recapture is taxed at your top income rate (up to 13.3%).
- Example: $100,000 prior depreciation = $25,000 IRS + $13,300 FTB added to your tax bill (per property!).
Flippers—who rarely hold property long—face unwanted income spikes, often catapulting them into higher current year brackets. Passive investors with many properties risk “bracket stacking” on sales in one year.
KDA Case Study: Rental Investor Sidesteps a $110,000 Overpayment
Roberto (San Jose-based, owns four single-family rentals) sold his longest-held property in early 2025 for a $775,000 gain. His longtime CPA warned him to expect the following:
- Federal LTCG tax (20%): $155,000
- NIIT (3.8%): $29,450
- CA tax (13.3%): $103,075
- Depreciation recapture (IRS & FTB): $37,500 + $19,950
Roberto nearly accepted a total tax hit exceeding $344,975. After consulting KDA, we:
- Restructured the sale into a strategic 1031 exchange, rolling proceeds into two out-of-state multifamily deals.
- Documented and allocated his improvements and closing costs (raising his basis and lowering the reported gain by $90,000).
- Filed FTB Form 3840 for the out-of-state exchange, eliminating a CA “trailing tax” on future sales.
- Took advantage of federal and state cost segregation studies (see our cost segregation guide for technical breakdowns).
Savings vs. initial scenario: $110,000 for 2025 (after all costs). Roberto paid $7,500 for KDA’s strategy and compliance work, netting a 14.6x return on investment and keeping his “retirement relocation” dreams alive.
Red Flags That Trigger California FTB Audits on Capital Gains
The FTB receives direct data from IRS and closing agents (via Form 593 for CA properties). Major audit triggers:
- Mismatched sales proceeds between federal and CA filings.
- 1031 exchange paperwork errors or late filings (especially FTB Form 3840 tracking out-of-state purchases).
- Big improvements claimed in basis (must have receipts, contract details).
- Substantial “unreported” owner improvements on flip sales.
- Reporting a CA property sale as “out-of-state” gain or omitting it from a CA nonresident return. (Out-of-state owners must report all CA gains.)
Audit rates remain higher for sellers with more than $1M gain and for repeat “exchangers” who move proceeds out of California. (See FTB’s withholding guidelines.)
Pro Tip: Always match your transaction paperwork, IRS Form 8949, and all CA forms. Keep digital backups for 7+ years—CA sometimes audits real estate gains years later, especially if the property has changed hands between family or trusts.
Next-Level Strategies to Lower Your California Capital-Gains Tax Bill (2025 Edition)
- Pre-sale cost segregation: Identifies depreciable portions and improvements, raising basis, lowering gain.
- Multi-asset exchanges: Mix CA and non-CA property in 1031s to defer as much state tax as possible.
- Installment sales with planned “basis step-up” for heirs: Advanced estate planning aligns installment proceeds with death, potentially stepping up basis and slashing state tax.
- Opportunity Zone rollovers: Still viable for some, but beware: real estate mostly qualifies only in newly designated zones—consult a CA Opportunity Zone specialist.
- Entity structuring (“entity layering”): Aligns multiple holding LLCs for staggered exits, smoothing income spikes and reducing audit risk (see KDA’s entity guide).
Each strategy comes with strict IRS/FTB forms and deadlines. Consult IRS Publication 544 and confirm guidance with the latest FTB updates.
FAQ: Your Burning California Real Estate Capital-Gains Questions
Do I get the $250,000 / $500,000 exclusion if I lived in my rental for 2 years?
If the property was your principal residence for at least 2 out of the last 5 years, you may exclude $250K (single) or $500K (married) of gain—but only on the portion that was your primary home. Mixed-use or partial rentals reduce this benefit proportionally. CA applies the same exclusion, with additional tests for residency and intent.
I’m moving out of CA right after selling—does this help?
No. If the real estate is in California, you owe CA tax on gain regardless of your current residency. CA pursues out-of-state sellers and will withhold tax at closing.
If my buyer defaults on an installment sale, do I still owe CA tax?
If you “repossess” the property or sell the note, you report all deferred gain at once—so you could still owe a big payment in the year of default or note sale. KDA can help you time and structure contracts to limit this risk.
Can I still do a 1031 exchange after the 2025 closing?
Yes, provided you identify replacement properties within 45 days and complete the purchase in 180 days. However, 2025’s tightening on paperwork and “like-kind” definitions means you must act quickly and document everything.
Social-Shareable Insight
The FTB doesn’t care how little you profit on a real estate deal—unless you plan, California can take 13 cents of every dollar.
Book Your California Real Estate Tax Strategy Session
Don’t get blindsided by a six-figure state tax bill. Our KDA strategists help California investors legally defer, reduce, and defend real estate capital gains using the latest 2025 rules. Book your session now and keep more from your next sale.
This information is current as of 7/24/2025. Tax laws change frequently. Verify updates with the IRS or FTB if reading this later.
- Ready for an entity review? Explore KDA’s entity structuring services.
- More real estate tax tips at our services hub.
- Questions about passive income taxes? Get custom tax planning help.
- California taxes your real estate gains at up to 13.3%—federal rates don’t protect you.
- 1031 exchanges and cost segregation are must-use tools for CA investors selling in 2025.
- Review FTB Form 593 and your federal filings to avoid costly audit missteps and overpaying state tax.
