Key Takeaways:

• A principal residence is your primary home, where you spend most of your time and the address you use on identification documents
• This distinction impacts whether you qualify for the capital gains tax exemption
• In California, capital gains are taxed the same as your regular income, but the IRS applies different rates to long-term capital gains
• The capital gains exemption is $250,000 for single filers and $500,000 for joint filers, and you must have lived in the home for at least two years out of the last five
• Eight ways to avoid tax trouble with a home sale:
  1. Calculate capital gains correctly
  2. Do everything you can to qualify for the exemption
  3. Don’t forget property taxes
  4. Account for California’s transfer tax
  5. Take a partial exemption if possible
  6. Take advantage of improvements
  7. Report the sale correctly
  8. Hire a tax professional

Residential sales can be stressful and may take a long time to finalize. You also have to consider all the tax and legal implications of the sale, on top of figuring out where you and your family will be living next. 

Your Capital Gains on the home sale may turn into a big profit for you, depending on how long you’ve had the home and the current real estate market. Don’t forget, however, that you will usually have to pay capital gains taxes on that profit.

Avoiding the California tax on the sale of a principal residence in 2022 may be one of your top concerns for the upcoming tax season. This guide walks through what is considered a principal residence, capital gains tax facts, and eight ways to avoid tax trouble when you’re selling a residence.

What Is a Principal Residence Sale?

A principal residence sale occurs when you sell your primary home. This is where you live most of the time. You may be selling your residence because you bought a different one, you’re making a big move to another state or country, or you’re going to live in a different property you own. 

California taxes property owners on the capital gains they receive from a residential sale, though not all states do. California treats the gain as if it were ordinary income, so the same income tax rate applies to what you earn from the sale. However, federal capital gains taxes are different based on short-term and long-term capital gains (discussed more below).

The IRS states that people can only have one main home at a time. How much time you spend at each property you own is the biggest factor in determining where your primary residence is. Wherever you spend the majority of time during the year is usually your principal residence. Other factors include the following:

• The address you use on documents like your driver’s license, tax return, voter registration, and U.S. Postal Service registration
• The home that’s close to where you work or bank, where you live with your family, or near clubs and organizations you belong to

Many types of homes can be considered your primary home. It could be a condo, a single-family home, a cooperative apartment, a mobile home, trailer, or even a houseboat. These factors are all important to help you determine how much tax you pay on your home sale. You need to first ensure that it is actually your principal residence.

Capital Gains Tax on the Sale of a Principal Residence

One of your most important considerations when selling your home is capital gains tax. This liability can be significant. The IRS offers exemptions, however, so you don’t have to pay tax on the full gain of the sale if you meet certain requirements. Here’s what you need to know about capital gains tax on principal residence sales:

Capital Gains Tax

This tax applies to the difference between the home’s basis, which is what you paid for it, and the price you’re selling it for now. You’ll need to pay both federal and state capital gains tax. The Franchise Tax Board administers this tax for those in California. The state of California treats gains the same as income, so it taxes them at your income tax rate.

Federal Short-Term and Long-Term Gains

The IRS taxes short-term gains (profit from assets sold within a year of purchasing them) the same as income. Long-term gains (profit from assets sold after holding for over a year) are taxed at either 0%, 15%, or 20% depending on total capital gains. California residents selling a home need to factor in both state and federal capital gains tax requirements.

Relevant Expenses

In California, you can also use expenses related to a home sale, which are deductions to the capital gain amount. These could be real estate service costs or similar expenses you paid in the selling process. You can also typically factor in home improvements you made during ownership, which are added to the amount you originally paid for the home.

Capital Gains Tax Exemption

It’s worth noting that, fortunately, there are some exemptions so you don’t have to pay taxes on your full capital gains. Single taxpayers have an exemption of $250,000, and married taxpayers have a $500,000 exemption. Say you bought the home for $500,000 originally and you sold it for $800,000. That’s a $300,000 capital gain. Single taxpayers would only have to pay taxes on $50,000 of the gain. If the gain is less than $250,000, an individual will not have to pay capital gains tax, and the same is true for sales less than $500,000 for married couples. This exemption only applies to home sales where it was your primary residence, not investment properties or second homes.

Automatic Disqualifications

Some situations are automatically disqualified from the exemption. You can’t have acquired the property through a like-kind exchange (1031 exchange) in the last five years, for example. You also can’t be subject to the expatriate tax. 

Ownership Requirement

You must have owned the home for at least two of the last five years to qualify for the exemption. At least one spouse in a married couple must meet this requirement. 

Residence Requirement

You must also have owned the home and used it as your residence for at least two years of the last five years, and those years can fall anytime within that period. Both spouses must meet the residence requirement to get the full joint exclusion of $500,000.

Look-Back Requirement

You can’t have sold another home in the last two years before the date of the sale, or you can’t have taken the gain exclusion for that sale to qualify for it now. The exclusion can only be claimed once in a two-year period.

Eligibility Exceptions

The IRS outlines several exceptions to the capital gains tax exemption. Make sure none of these apply:

• You separated or divorced from your spouse during homeownership
• A spouse died during homeownership
• Vacant land was part of the sale
• You owned and sold a remainder interest, which is the right to own a home at a future date
• Your last home was condemned or destroyed
• You were a service member while you owned the home
• You bought or are selling the home in a like-kind/1031 exchange
• The property was used as a vacation home or rental after 2008, or part of the home was used for business or rental purposes

Partial Gain Exclusions

You still may be able to claim a partial exemption if you don’t meet all the eligibility requirements. This may apply if your sale was because of a change in work location, it was a health-related move, or an unforeseeable event caused the move.

Understanding the capital gains tax can help you properly plan for a home sale in California. You want to be sure you qualify for that tax exemption since it can help you save a significant amount of money on the sale. Talk to a tax attorney when you need guidance.

Eight Ways to Avoid Tax Trouble With a Home Sale

Selling your principal residence is a huge step. It can lead to a big profit, helping your family move on to the next home or goal. The process, however, needs to be treated with care so you don’t get into trouble with taxes or are surprised by a large tax bill. These tips will help you avoid issues:

1. Calculate Capital Gains Correctly

Capital gains seem pretty straightforward, but there are a few things to factor in. You need to know what you paid for the home originally and any commissions you paid. You also need to have clear numbers on the improvements you made to the home, with written receipts or other forms of proof for these costs. Subtract all of those costs from the current sale price to get the actual gains.

2. Do Everything You Can to Qualify for the Exemption

Think about capital gains tax implications when you’re considering selling your home. Consider waiting, for example, if you haven’t yet lived there for two years of the last five. Some homeowners are in no rush and should take advantage of the exemption however possible. Getting the full exclusion of gains is the best way to avoid paying a lot in capital gains tax.

3. Don’t Forget Property Taxes 

Homeowners are required to pay property taxes each year, as you know from your years of homeownership. Figure out if you have paid any property taxes in advance while the sale is occurring. You can typically negotiate this with the new buyer. Unpaid property taxes at the time of the sale mean you can prorate them until the end of the escrow.

4. Account for the Transfer Tax

California also issues a transfer tax on home sales. The current rate is $1.10 for every $1,000  on the home’s sale price. All California counties have to pay the same rate. Some cities and counties also add more transfer taxes on top of this. Talk to a tax professional who can advise about your area and requirements. The seller usually pays the transfer tax, but sometimes it can be part of negotiations with the buyer.

5. Take a Partial Exemption if Possible 

You may be able to take a partial exemption even if you don’t meet all qualifications for the full exclusion amount. Consider whether you were unable to live in the home for two years because of a move related to work, a death, or a medical issue.

6. Take Advantage of Improvements

Any home improvements should be factored into your home’s cost basis. This helps you increase that amount and lower what you pay in capital gains tax. Make sure you have proof of all costs associated with these improvements.

7. Report the Sale Correctly for Tax Purposes

Your home sale will be part of your federal tax return, so make sure to report accurate numbers when you file. You will also need to file the California Capital Gain or Loss Schedule D 540 form if the gain from your sale was more than $250,000 for single filers and $500,000 for joint filers.

8. Hire a Tax Professional

Selling a home comes with many legal and tax implications you never want to overlook. Make sure you handle everything properly by hiring a tax professional as part of your home sale team. A tax attorney can explain how the process works from start to finish and ensure you do everything according to the current laws in your area of California.

These tips can help give you peace of mind when selling your principal residence in California. Make sure the residence is your primary home or you won’t be able to take the significant capital gains tax exclusion. It’s also a good idea to make sure all receipts and home documents are in writing and stored in a secure location.

Contact Silver Tax Group With Questions About Principal Residence Sales 

Selling your home can be an exciting step, but it can also be stressful if you aren’t prepared. Capital gains tax applies to the sale of your home, but as long as it’s your primary residence and you meet all qualifications, you can exclude some of your gains to lower your tax liability. 

The team of tax attorneys at Silver Tax Group can answer any questions you have about this process. We can explain how tax law works and help you navigate your local California laws. We also help with a range of tax issues like emergency tax services, debt relief, audits, and tax defense. Reach out to Silver Tax Group today to speak to an expert about the California tax on the sale of a principal residence.

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