First, a note: I am not a CPA, so you should talk to a CPA to obtain tax advice specific to your situation. I get these questions from investment property clients often when they are wondering about their tax liability when selling a property: What are the tax implications of selling an investment property California? How can I reduce capital gains tax when selling a rental property? Should I do a 1031 exchange when selling a Sacramento rental property?

If you own a duplex, triplex, fourplex or other investment property in California and you’re starting to think about selling, the conversation almost always comes back to one thing: taxes. At some point, everyone wonders what they are actually going to owe, if there is a way to reduce tax, or should I be doing a 1031 exchange? These are exactly the right questions to be asking early, because the answers will inform what you decide to do next.

When you sell an investment property, there are a couple primary tax considerations. The first is capital gains tax, which is tax that is based on the difference between your sale price and your adjusted basis. Your adjusted basis generally includes what you originally paid for the property, plus improvements, minus the depreciation you’ve taken over time. The second piece is depreciation recapture. Over the years, you’ve likely benefited from writing off depreciation. When you sell, the IRS recaptures that benefit and taxes it separately. In California, there’s an added layer, since the state taxes capital gains as ordinary income rather than at a lower rate.

There are ways to think strategically about reducing that tax burden, but they depend on your specific situation. Sometimes it comes down to timing. Selling in a year when your overall income is lower could put you in a more favorable tax bracket. In some situations, selling in a year when you have other investment losses can help offset capital gains. In other cases, it’s about making sure your adjusted basis is accurate and includes all eligible improvements and expenses. If you’ve lived in part of the property, such as one unit of a duplex, you may qualify for a partial primary residence exclusion, although that can get nuanced quickly. Because there isn’t a one-size-fits-all answer, this is where involving a CPA early can be especially helpful.

Something to note that tends to take some sellers by surprise is the California Franchise Tax Board (FTB) withholding. For the sale of a non-primary residence in California the FTB requires escrow to automatically withhold 3.33% of the sales price and remit that as a prepayment of your state tax liability, unless instructed otherwise. Sometimes 3.33% of the sales price is a huge overpayment to the FTB, and on the flipside it can also be an underpayment. Your escrow holder will ask you to complete FTB Form 593e to estimate the amount of the seller’s gain, loss, or zero gain for withholding purposes and to calculate an alternative withholding calculation amount. Engaging a CPA can be helpful in completing this form. But if you do not instruct escrow to withhold a different amount (or no amount) then escrow will withhold 3.33%.

A 1031 exchange is another option that often comes up. This allows you to defer capital gains taxes by reinvesting the proceeds from your sale into another investment property. There is not FTB withholding in a 1031 exchange. You’re not eliminating the tax, but postponing it. This can be a powerful strategy if your goal is to stay invested in real estate or reposition your portfolio. However, it comes with strict rules and timelines. You need to set up the 1031 exchange before and during your sale, you absolutely cannot take receipt of the net proceeds of your sale, and you should engage with with a “qualified intermediary” to handle the documentation and funds. You will need to identify a replacement property within a specific 45-day window, and then close on that replacement property within 180 days. It’s also important to consider whether it aligns with your goals. If you’re looking to simplify your life, reduce management responsibilities, or fully cash out, a 1031 exchange may not be the right fit.

Taxes, timing, and long-term goals all come into play. Some owners choose to sell and reinvest, while others decide it’s time to cash out and move on. If you’re starting to think about selling, one of the most helpful first steps is understanding your numbers and your options. From there, you can make a more informed decision about what comes next.

Contact Erin Stumpf at Coldwell Banker Realty (DRE#01706589) with questions today: call/text 916-342-1372 or email to erin@erinstumpf.com