What is the Capital Gains Tax When You Sell Your Home: California v. Tennessee

When you sell your home, you have to consider your tax hit, and that tax hit is the capital gains tax. The federal government (aka IRS) will tax you, and your state will tax you. This article will discuss the federal tax and compare California versus Tennessee state taxes.

What is Capital Gain?

Capital gain is the net sale proceeds from the sale of your home minus your tax basis in your home.

Your tax basis is the price you paid for your home plus the costs of any improvements. If you paid $500,000 for your home and a few years later built a pool and landscaped your yard for $100,000, your tax basis in your home would be $600,000.

If you sell your home many years later, and after realtor commissions and closing costs, your net sale proceeds are $1,000,000, your capital gain would be $1,000,000 - $600,000 = $400,000.

Note. Your mortgage has no impact on the capital gain. Your mortgage is a debt, and it does not factor into the value of the property and the capital gain calculation.

How much will you owe the IRS on this $400,000 capital gain?

Federal Capital Gains Tax

The IRS has two categories for capital gain: short-term capital gains and long-term capital gains. 

Short-term capital gains are gains on assets held for less than one year before the sale. The IRS treats short-term capital gains as ordinary income.

Long-term capital gains are gains on assets held for more than one year before the sale. References to the federal capital gains tax rate in this article are to long-term capital gains.

Here are the 2024 federal capital gains tax rates:

Single Taxpayers

• 0% on income up to $44,625
• 15% on income between $44,626 and $492,300
• 20% on income over $492,300

Married Taxpayers Filing Jointly

• 0% on income up to $89,250
• 15% on income between $89,251 and $553,850
• 20% on income over $553,850

IRC Section 121

While we are all aware that the IRS wants its pound of flesh, there is a code section that will reduce or eliminate the federal capital gain tax for many home sales.

Internal Revenue Code section 121 offers a capital gains tax exclusion of $250,000 for single people and $500,000 for a married couple that files a joint tax return. But there are conditions to the exclusion. You must have owned and lived in the home as your primary residence for two of the last five years before the sale.

Under our scenario above, if the homeowner were single, her federal capital gain would be $400,000 - $250,000 = $150,000, and her federal capital gain tax would be $150,000 x 15% = $22,500.

If the homeowners were married, there would not be a federal capital gain because the $400,000 capital gain is less than the $500,000 exclusion.

California Tax

In addition to the federal capital gain tax, there is the dreaded state tax, and, as you might suspect, California has a big one.

Technically, however, California does not have a capital gains tax. That's good, right? Well, no, because California treats capital gains as ordinary income. California does not have a separate capital gains rate, but it has a significant ordinary income tax rate.

Here are the 2024 California income tax rates:

Single Taxpayers

• 1% on income up to $10,099
• 2% on income between $10,100 and $23,942
• 4% on income between $23,943 and $37,788
• 6% on income between $37,789 and $52,455
• 8% on income between $52,456 and $66,295
• 9.3% on income between $66,296 and $338,639
• 10.3% on income between $338,640 and $406,364
• 11.3% on income between $406,365 and $677,275
• 12.3% on income over $677,276
• Additional 1% surcharge on income over $1,000,000 (Mental Health Services Tax)

Married Taxpayers Filing Jointly

• 1% on income up to $20,198
• 2% on income between $20,199 and $47,884
• 4% on income between $47,885 and $75,576
• 6% on income between $75,577 and $104,910
• 8% on income between $104,911 and $132,590
• 9.3% on income between $132,591 and $677,278
• 10.3% on income between $677,279 and $812,728
• 11.3% on income between $812,729 and $1,354,550
• 12.3% on income over $1,354,551
• Additional 1% surcharge on income over $1,000,000 (Mental Health Services Tax)

California Withholding Tax at Escrow Closing

When you sell a home in California, you must complete Franchise Tax Board (FTB) form 593. The form asks whether there is a capital gain on the sale. If so, the California FTB will generally withhold 3.33% of the gross sale price as an advance payment to the state on the capital gain on the sale. Later, when you file your tax return for that year, if you determine the tax on the gain should have been less than the withholding, you can request a refund.

Step-Up in Basis

Earlier in this article, we described how the tax basis in your home is the purchase price plus the costs of home improvements. If you have owned your home for many years, the tax basis may be much lower than the fair market value because your home has appreciated. If so, there may be a capital gain when you sell your home.

However, if you inherited your home or your spouse predeceased you, you may have received a step-up basis equal to the home's value on the date of death.

Inherited property receives a step-up in basis. If your dad bought his home forty years ago for $100,000, and at the time of his death, it was worth $1,000,000, and he left it to you in his living trust, your basis in his home is $1,000,000. This is called a "step-up" basis.

The step-up basis may also be available on a spouse's death. If the home was either community property or the deceased spouse's separate property, then the surviving spouse will receive a step-up basis for the entire home value.

Step-Up Basis and California Withholding Tax

Not long ago, my client's wife died. This was a second marriage, and she had a rental home, which remained her separate property. And her rental home was owned in her separate property living trust.

My client was the successor trustee of his wife's separate property living trust. Soon after his wife's death, he sold the home. At the escrow signing, he had to complete FTB form 593 and disclose whether there was a capital gain subject to withholding.

There was no capital gain because my client received a step-up basis in the home. However, his accountant completed the form for him, and the accountant wasn't clear about the step-up basis rule. He indicated on the form that there was a capital gain, and as a result, the FTB withheld $150,000 from the sale proceeds. This was a mistake.

The client and his accountant now have to contact the FTB to determine if they can recover the excess withholding now rather than later. In all likelihood, he won't be able to get the refund until after he files the trust tax return. 

Tennessee Tax

By contrast, let's compare California's tax with Tennessee's. We are using Tennessee as the comparison state to California because we have friends, family, and many clients who have recently moved to Tennessee. 

Here are the 2024 Tennessee tax rates:

0%

Well ... at least California is beautiful, not humid, and no cicadas.