Capital Gains When Selling a House

Most Newport Beach homeowners never think about capital gains when selling a house until a realtor mentions the number they might actually walk away with after tax. Given how much coastal and near-coastal property values have climbed over the past two decades, a primary residence purchased in the 1990s or 2000s can carry a gain well past the exclusion limits that most sellers assume will cover them.

A single filer can exclude up to $250,000 of gain on the sale of a primary residence, and a married couple filing jointly can exclude up to $500,000, provided the home was owned and used as a primary residence for at least two of the five years before the sale. For a lot of the country, that exclusion covers the entire gain. In Newport Beach, where a modest home purchased decades ago can now be worth several times its original price, it is common for the exclusion to cover only a portion of the gain, leaving the remainder taxable.

The portion of gain above the exclusion amount is taxed as a long-term capital gain at the federal level, assuming the two-year ownership and use test is met, plus California income tax on the same amount with no reduced rate. There is no 1031 exchange available for a primary residence sale, since that deferral tool is limited to investment or business property. Sellers facing a large excess gain sometimes look at an installment sale structure or timing the sale to manage the year's overall income, but there is no mechanism that defers gain on a primary residence the way an exchange defers gain on a rental.

A home that was rented out for a period, then converted back to a primary residence, or a property with a rented accessory dwelling unit, requires the gain to be allocated between the excludable personal-use portion and the taxable rental-use portion. Depreciation claimed during any rental period is recaptured regardless of how the property was used afterward, and does not qualify for the Section 121 exclusion even on the portion of gain that otherwise would.

• two-of-five-year ownership and use test confirmed before listing
• gain allocated between personal and rental use if applicable
• depreciation recapture calculated separately for any rental period
• excess gain above the exclusion identified before the sale, not after

Because the exclusion amount has not changed in decades while coastal property values have grown substantially, Newport Beach sellers benefit from running the actual numbers with a tax advisor well before listing, rather than assuming the standard exclusion will cover the full gain. Knowing the expected taxable amount in advance also affects decisions like whether to sell in a year with lower other income, or whether an installment structure makes sense for a portion of the proceeds.

Basis is not limited to the original purchase price. Capital improvements made over the years an owner held the home, from a kitchen remodel to a new roof to an addition, increase basis and reduce the taxable gain dollar for dollar. Homeowners who have lived in a Newport Beach property for twenty or thirty years and never kept receipts or permits for major improvements often leave money on the table simply because they cannot substantiate the higher basis when it comes time to calculate the gain. Pulling together old permits, contractor invoices, and even paid checks well before a sale is listed makes this part of the calculation far more accurate than trying to reconstruct it from memory after an offer is already in hand.