Seller Guide
The Section 121 exclusion, adjusted basis, depreciation recapture, California's treatment of gain, and the withholding your escrow will apply at closing.
Long-held Los Angeles property produces gains that outgrew the federal exclusion years ago. A family that bought in the 1990s and is selling now may be looking at a taxable gain several times the size of the exclusion they assumed would cover it, and the difference between a well-prepared file and a poorly-prepared one is measured in real money. Most of that difference is not clever planning. It is documentation of basis, an accurate account of any period the property was rented, and a decision made before the listing rather than after an offer arrives.
This guide sets out the framework: how gain is calculated, what the Internal Revenue Code Section 121 exclusion covers and what its ownership, use and frequency tests require, what does and does not increase adjusted basis, how depreciation recapture and non-qualified use periods reduce the exclusion where a home was rented, how California treats capital gain differently from the federal system, and what the Franchise Tax Board and, for foreign sellers, the Internal Revenue Service require to be withheld through escrow. It also explains where a 1031 exchange fits and where it does not.
This is not tax advice and cannot be. The rules summarised here have exceptions, elections, timing requirements and interactions that depend entirely on facts this guide does not know, including your filing status, your holding history, whether the property was ever rented or used for business, whether it came through an estate or a trust, and where you are resident. Every figure and rule cited is attributed to the agency that publishes it. Take the framework to a CPA or tax attorney before the property is listed, when there is still time for the answer to change what you do.
Gain is the amount realised on the sale less the adjusted basis of the property. Amount realised is the sale price reduced by the costs of selling, which generally include brokerage compensation, transfer taxes, title and escrow charges and similar transaction costs. Adjusted basis starts with what you paid, adjusted upward for capital improvements and certain acquisition costs and downward for items such as depreciation previously allowed or allowable and casualty loss deductions. Neither figure is the number on the settlement statement, and neither is what your equity looks like at closing.
That last point deserves emphasis because it is the most common source of alarm. Cash proceeds and taxable gain are entirely different quantities. A seller who refinanced repeatedly may walk away from closing with modest cash and still face a large gain, because borrowing against a property does not change basis. A seller who paid cash and never borrowed may receive a very large wire and owe less than expected because their basis is high. Model both separately, and give your CPA the whole history rather than the closing statement alone.
Where the property was inherited, the analysis changes at the front end. Property acquired from a decedent generally takes a basis determined by reference to value at the date of death, which can eliminate decades of accumulated appreciation from the calculation. That interacts with California property tax rules under Proposition 19 in ways that are separate and sometimes counterintuitive, since a favourable income tax basis and a favourable property tax base year value are governed by different rules. Estates and trusts selling Los Angeles property should have both analysed together.
The Internal Revenue Service states that a seller may exclude up to $250,000 of gain from income, or up to $500,000 on a joint return with a spouse, on the sale of a main home. The exclusion is not automatic and it is not a deduction; it removes qualifying gain from income entirely, and gain above it remains taxable. For long-held Los Angeles property the exclusion is frequently a modest fraction of total gain, which is why sellers who assume it will absorb the whole result are so often unpleasantly surprised.
Three tests govern eligibility. The ownership test requires that you owned the home for at least 24 months out of the five years leading up to the date of sale. The use test requires that you used it as a residence for at least 24 months of those same five years. The two periods must each fall within the five-year window but need not be the same 24 months. The frequency limitation provides that you are not eligible if you excluded gain from the sale of another home during the two-year period before this sale.
There are partial-exclusion provisions for sellers who fail the tests for specified reasons, and there are special rules for surviving spouses, for members of the armed services and certain other government personnel, and for divorcing couples. These are genuinely fact-dependent and worth an appointment rather than an internet search, particularly where a marriage, a death or a relocation sits anywhere in the timeline. Reporting also has rules of its own: the IRS requires the sale to be reported where a Form 1099-S is received or where the whole gain cannot be excluded, generally on Schedule D with Form 8949 where applicable.
Improvements increase basis; repairs do not. The Internal Revenue Service describes improvements as work that adds value, prolongs useful life, or adapts the property to new uses, giving examples such as additions, heating and air conditioning systems, security systems, a new roof or siding, flooring and built-in appliances. Costs of repairs or maintenance that are necessary to keep the home in good condition but do not add to its value or prolong its life, such as painting, fixing leaks and replacing broken hardware, do not increase basis. There is an important exception: where items that would otherwise be repairs are performed as part of an extensive remodelling or restoration, the entire job is treated as an improvement.
In a market where owners routinely spend heavily over decades, the distinction is worth real money, and the constraint is almost never the law. It is records. Basis is a claim you must be able to substantiate, which means contracts, invoices, permits, cancelled cheques, lender draw schedules and architect and contractor agreements, kept for as long as you own the property and for as long afterwards as your CPA advises. Sellers who assembled that file as they went are in a very different position from sellers reconstructing thirty years of work from memory, a shoebox and a handful of statements from a bank that no longer exists.
Two practical habits follow. First, if you are contemplating a sale in the next few years, begin the reconstruction now rather than during escrow, and ask your CPA specifically what documentation they will accept and in what form. Contractors, architects, designers and the permit records held by the Department of Building and Safety can often supply what personal files cannot, but all of them take time to respond. Second, keep the permit history and the improvement file together, because the same documents that support basis also support your disclosure obligations and your position on any unpermitted work. One assembly effort serves several purposes at once.
If any part of the property was rented or used for business and depreciation was claimed, the exclusion does not reach it. The Internal Revenue Service is explicit that you cannot exclude the portion of gain equal to any Section 1250(b)(3) depreciation adjustments allowed or allowable after 6 May 1997. Note the phrase allowed or allowable: the rule bites whether or not the deduction was actually taken, which is a trap for owners who rented a property informally and never depreciated it. That gain is recognised, and unrecaptured Section 1250 gain is taxed at a maximum federal rate of 25 percent under the IRS guidance on capital gains.
Separately, periods of non-qualified use reduce the exclusion. The IRS describes any period after 2008 during which the property was not used as a principal residence as generally constituting non-qualified use, with gain allocable to that period not eligible for exclusion. In practice this means a property converted from a rental into a residence does not become fully excludable simply by satisfying the two-year use test, because the allocation is made across the ownership period. Converting a long-term Los Angeles rental into a residence before selling is a strategy with a much smaller effect than sellers usually expect.
Both rules require an accurate history, and the history is usually messier than the owner remembers. Short-term rental periods, a guest house or accessory dwelling unit that was let separately, a home office deduction taken for several years, a period when the family lived abroad and rented the house out, and a stretch when an adult child paid rent all have potential consequences here. Give your CPA the whole chronology, including the years you are confident are irrelevant, and include the tax returns for those years if you have them. It is far cheaper to establish that a period does not matter than to discover after filing that it did.
At the federal level, long-term capital gain is taxed at preferential rates. The Internal Revenue Service describes rates of 0, 15 and 20 percent depending on taxable income, with the income thresholds for each adjusted annually, plus the maximum 25 percent rate on unrecaptured Section 1250 gain described above. A net investment income tax may also apply to higher-income taxpayers, and the Internal Revenue Service addresses that separately in its own guidance. All of that is federal, it depends on your filing status and total income for the year of sale, and it says nothing whatever about what California will do with the same gain.
California is different, and simpler in a way sellers do not enjoy. The Franchise Tax Board states plainly that California does not have a lower rate for capital gains and that all capital gains are taxed as ordinary income. There is no long-term holding benefit at the state level, no separate rate schedule, and no state analogue to the federal preferential brackets. There is also no California equivalent to a reduced rate for property held for many years. For a large Los Angeles gain, the combined federal and state exposure is materially higher than sellers who have only read federal guidance expect.
California does conform to the federal exclusion for the sale of a principal residence in its general treatment, but the conformity questions in California tax law are technical and change with legislation, so confirm the current position rather than assuming. If you have moved out of California, or are planning to before selling, the sourcing rules for gain on California real property are their own subject and are not solved by a change of residence. That is a question to ask a California tax professional early, because the answer often determines whether a move is worth making at all.
California requires withholding on sales of California real property unless an exemption applies. The Franchise Tax Board's standard rate is 3 1/3 percent of the total sale price. Withholding is remitted through escrow and reported on Form 593, the Real Estate Withholding Statement, which the Franchise Tax Board requires to be filed by the 20th day following the close of escrow. Sellers may alternatively elect an optional gain-on-sale calculation on Form 593 rather than the flat rate on the sale price. Withholding is not a tax; it is a prepayment credited against your California liability when you file.
The exemptions that matter to most residential sellers are the principal residence exemption and the small-transaction exemption. The Franchise Tax Board describes the principal residence exemption as available where the seller owned the property for at least two years during the five-year period before the sale and used it as a principal residence for any two years in that period, and separately exempts sales with a price of $100,000 or less, with multiple parcels in the same escrow counted together. Exemptions are claimed by certification on Form 593 signed under penalty of perjury, and falsely certifying carries a penalty of $1,000 or 20 percent of the required withholding, whichever is greater.
Where the seller is a foreign person, a separate federal regime applies. Under the Foreign Investment in Real Property Tax Act, the Internal Revenue Service states that the rate of withholding is generally 15 percent of the amount realised, that in most cases the buyer is the withholding agent, and that the tax is remitted with Forms 8288 and 8288-A. There is a complete exemption where the amount realised is $300,000 or less and the buyer intends to use the property as a personal residence, and a reduced rate is available in a band above that where the residence conditions are met. FIRPTA and California withholding are independent obligations, and a seller can be subject to both.
A like-kind exchange under Section 1031 defers gain on the disposition of property held for productive use in a trade or business or for investment. It is not available for a personal residence. For an owner selling a Los Angeles rental, a small apartment building or an investment property, it is often the single largest lever available, and it is also unforgiving on timing and process, with identification and closing deadlines and a requirement that a qualified intermediary hold the proceeds. The site's separate guide to 1031 exchanges covers the mechanics; the point here is that the decision must be made before closing, not after.
The two regimes interact in a specific way that catches people. The Internal Revenue Service states that you cannot claim the Section 121 exclusion if you acquired the home in a like-kind exchange and sold it within five years of the date it was acquired in that exchange. So an investor who exchanges into a property, converts it to a residence and then sells has a holding requirement to satisfy that has nothing to do with the ordinary two-out-of-five-year test, and the non-qualified use allocation applies on top of it. Mixed personal and investment histories need a professional to sequence properly.
A final point on the interaction with California withholding. A properly structured exchange can affect whether withholding is required at closing, but that determination is made on Form 593 and depends on how the transaction is documented and certified, so it has to be coordinated between your qualified intermediary, your escrow officer and your CPA before escrow closes rather than reconciled afterwards. This is a sequencing problem more than a legal one, and sequencing problems in this area are cheap to solve early and expensive, sometimes irreversibly so, to solve late. Have the conversation before you accept an offer, not after the buyer's deposit is in escrow.
Tax law, exclusion amounts, rates and withholding rules change and depend entirely on your own facts; nothing here is tax advice, and you should confirm current rules with the IRS and the Franchise Tax Board and obtain advice from your own CPA or tax attorney before acting.
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