Buying investment property in California can be very profitable, but also comes with important tax considerations. As a high-tax state, California real estate investors need to factor both state and federal taxes into their investment calculations. Key issues include capital gains tax when selling, passive loss limitations, depreciation recapture and property tax limits from Proposition 13. Understanding how these real estate taxes work is crucial when analyzing potential returns on rental properties or flips in California. This article will break down the key tax rules for California real estate investing so you can make fully-informed investment decisions.
California Imposes High Capital Gains Tax Rates on Investment Property Sales
California taxes capital gains on investment property sales at a top rate of 13.3%, the highest statewide rate in the U.S. When combined with the top federal long-term capital gains rate of 20%, your total tax bill on profits could approach 33%. The exact rate depends on your income level and how long you held the property, but real estate investors in California need to plan for hefty capital gains taxes when selling. This significantly impacts net profits, making it essential to model the after-tax returns on any property you’re considering purchasing in California.
Passive Loss Rules Limit Using Rental Property Losses to Offset Other Income
The federal passive activity loss rules limit your ability to use rental property losses to reduce your taxes on other income like wages or investment earnings. Passive losses (like those from a rental property) can only offset passive income. Any excess losses get carried forward to deduct against future passive income. So you generally cannot reduce your W-2 wages by deducting passive rental real estate losses. The passive loss limits apply nationwide, but are an extra consideration for California real estate investors already dealing with high state taxes.
You May Face Depreciation Recapture Taxes on Sale
While you can deduct depreciation each year on residential rental properties to offset operating income, you may have to pay it back at rates as high as 25% when you sell the property. This depreciation recapture applies to any depreciation claimed since January 1, 1987. Planning for this extra tax bill is crucial when analyzing the overall investment return potential of a California rental property investment.
Property Taxes Are Limited but Often Still High
While Proposition 13 caps annual property tax increases to 2% per year in California, taxes here are still among the highest in the U.S. Property tax rates on investment properties begin at 1% but often exceed 1.25% or more across parts of California, with levies calculated based on the purchase price less the Proposition 13 protection amount. So while your property taxes won’t surge each year, the baseline can still take a big bite out of rental income.
California real estate investors face state capital gains and property taxes far above U.S. averages, passive loss limits on deductions, and depreciation recapture bills when selling. Factoring taxes into projections is crucial for making fully-informed investment property purchase decisions.