UNDERSTANDING CAPITAL GAINS TAX IN CALIFORNIA

California's capital gains tax can significantly influence the financial landscape for investors residing in the Golden State. It’s important to consider how this tax may directly affect your investment strategies and long-term financial objectives.

Selling a profitable asset without considering the capital gains tax implications could lead to an unexpected tax liability, reducing overall returns. Navigating the complexities of both federal and state capital gains tax isn't just about compliance – it's an important component of effective financial planning – so understanding how it may impact your wealth and how you manage it is essential.

Let’s take a closer look.

THE BASICS OF CAPITAL GAINS TAX FOR CALIFORNIA RESIDENTS

It’s important to understand your state and federal capital gains tax obligations and how they may impact your financial planning and investment management. To navigate capital gains tax effectively, it's important to first familiarize yourself with key terms and definitions.

• Capital gain: The profit realized when you sell a capital asset, such as stocks, bonds or real estate, for more than its purchase price
• Capital loss: The loss incurred when you sell a capital asset for less than what you paid for it
• Short-term capital gains: Gains from the sale of assets held for one year or less, taxed at your ordinary income tax rate
• Long-term capital gains: Gains from the sale of assets held for more than one year, taxed at lower rates than short-term gains
• Taxable income: Your total income subject to taxes after accounting for deductions and exemptions
• Tax bracket: The range of income levels taxed at specific rates (higher income typically faces higher tax rates)
• Adjusted gross income: Your gross income minus certain adjustments, used to determine your taxable income
• Tax liability: The total amount of tax owed to the government
• Investment property: Real estate purchased to earn a return through rental income, future resale or both

Federal tax rates can significantly impact your investment returns. For investors, higher income levels may place you in tax brackets where capital gains are taxed at elevated rates. This makes understanding the distinctions between short-term and long-term capital gains a key step to success. Typically, holding assets for more than a year can lower your tax rate on gains, which can enhance your net returns.

In California, however, the distinction between short-term and long-term capital gains is treated differently. Here, capital gains are taxed as ordinary income, regardless of the holding period. This means, when it comes to your state capital gains tax:

• No preferential rates: Unlike federal taxes, California does not offer lower tax rates for long-term capital gains
• Ordinary income tax rates apply: Capital gains are subject to the same progressive tax rates as regular income, which range from 1% to 13.3%
• Impacts all taxpayers: Both short-term and long-term gains can push taxpayers into higher tax brackets due to increased taxable income

Understanding these nuances is essential. Recognizing that capital gains will be taxed at your ordinary income tax rate can influence your decisions on when and how to sell assets.

FEDERAL CAPITAL GAINS TAX RATES

Setting aside your state tax obligations for a moment, let’s first take a look at the federal capital gains landscape. Current federal capital gains tax rates are structured to favor long-term investments:

• Short-term capital gains: Taxed at ordinary income tax rates, which range from 10% to 37%, depending on your taxable income and filing status
• Long-term capital gains: Taxed at preferential rates of 0%, 15% or 20%
• Net investment income tax: Additional NIIT of 3.8% for taxpayers with income greater than $200,000 (single or head of household filers), $250,000 (married couples filing jointly or qualifying surviving spouse with dependent child) or $125,000 (married filing separately)

Here's how long-term capital gains rates apply to different income brackets:

• 0% Rate
  • Single filers and married filing separately with taxable income up to $47,025 in 2024 or $48,350 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income up to $94,050 in 2024 or $96,700 in 2025
  • Head of household with taxable income up to $63,000 in 2024 and $64,750 in 2025
• 15% Rate
  • Single filers with taxable income between $47,025 and $518,900 in 2024 or between $48,350 and $533,400 in 2025
  • Married filing separately with taxable income between $47,025 and $291,850 in 2024 or between $48,350 and $300,000 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income between $94,050 and $583,750 in 2024 or between $96,700 and $600,050 in 2025
  • Head of household with taxable income between $63,000 and $551,350 in 2024 or between $64,750 and $566,700 in 2025
• 20% Rate
  • Single filers with taxable income over $518,900 in 2024 or $533,400 in 2025
  • Married filing separately with taxable income over $291,850 in 2024 or $300,000 in 2025
  • Married couples filing jointly or qualifying surviving spouse with taxable income over $583,750 in 2024 or $600,050 in 2025
  • Head of household with taxable income over $551,350 in 2024 or $566,700 in 2025

There are a few other exceptions where capital gains may be taxed at rates greater than 20%, such as gains from certain qualified small business stock, collectibles and real property.

CALIFORNIA’S CAPITAL GAINS TAX RATE

In California, the tax structure for capital gains is integrated into the state's progressive income tax system. This approach means that high-income earners could face tax rates as high as 13.3% on their capital gains – the highest state tax rate in the country.

For individuals with substantial investment income, this structure has significant implications:

• Increased tax liability: Capital gains can elevate your taxable income, potentially moving you into a higher tax bracket
• Impact on investment returns: The lack of differentiation between short-term and long-term gains may affect your net returns from investments
• Strategic planning necessity: To mitigate the tax impact, strategic financial planning becomes crucial

Considering these factors, it's essential in California to develop strategies to help minimize capital gains tax liability effectively.

STRATEGIES FOR MINIMIZING CAPITAL GAINS TAX LIABILITY

Effective financial planning involves adopting strategies to help reduce your tax liability. For California residents, this is particularly important due to the state's taxation rules. By implementing thoughtful approaches, investors can preserve more of their investment income and enhance their overall financial outcomes. But, how?

Embrace Long-Term Investing

While it won’t help you with California state capital gains tax, focusing on long-term investments can still be one of the most straightforward ways to help minimize federal capital gains tax. Holding assets for more than one year qualifies you for the lower long-term capital gains tax rates, which are significantly more favorable than short-term rates. This strategy not only reduces your tax rate but also allows your investments more time to potentially grow.

Implement Tax-Loss Harvesting

Tax-loss harvesting works by strategically selling investments that have declined in value. The losses realized can offset capital gains from other investments. If your losses exceed your gains, you can even offset up to $3,000 of ordinary income annually, with any additional losses carried forward to future tax years.

Here’s how this strategy can be beneficial for high-net-worth individuals in California:

• Identify underperforming assets: Review your portfolio to pinpoint investments that haven't performed as expected
• Sell to realize losses: Selling these assets locks in the capital loss, which can then offset gains elsewhere
• Maintain investment strategy: To maintain your investment strategy, reinvest the proceeds in assets that align with your goals but aren't substantially identical
• Mind the wash-sale rule: Avoid purchasing the same or substantially similar asset within 30 days before or after the sale so your losses can remain deductible

Tax-loss harvesting requires careful planning and timing. When used effectively, it can enhance your after-tax returns and contribute to a more tax-efficient portfolio.

Consider 1031 Exchanges

For real estate investors, a 1031 exchange offers a powerful tool to potentially defer capital gains taxes. This provision allows you to sell an investment property and reinvest the proceeds into a like-kind property, deferring the capital gains tax liability.

Key aspects of a 1031 exchange include:

• Like-kind property: The replacement property must be of the same nature or character
• Strict timelines: You have 45 days to identify potential properties and 180 days to complete the exchange after selling your original property
• Qualified intermediary: An independent party must facilitate the exchange to comply with IRS regulations

By leveraging a 1031 exchange, you can continue allowing your real estate investments to grow without the immediate tax impact, potentially preserving more capital for future opportunities.

Use Tax-Advantaged Accounts Strategically

Tax-advantaged accounts, such as 401ks and individual retirement accounts, offer a smart way to help minimize the immediate tax impact of capital gains. These accounts are designed to let your investments grow without triggering taxes until specific conditions are met, making them a valuable tool for long-term financial planning.

Here are some other advantages:

• Tax-deferred growth: Investments held within these accounts accumulate earnings, including capital gains, without being taxed immediately. You only pay taxes when you withdraw funds.
• Lower taxable income: Contributions to traditional IRAs and 401ks can reduce your taxable income in the year of contribution, potentially keeping you in a lower tax bracket.
• Optimized withdrawals: By planning withdrawals strategically during retirement – when your income may be lower – you can reduce the overall tax burden on your investments.

Careful management of contributions and withdrawals not only supports tax efficiency but also aligns with long-term financial goals, whether you're planning for retirement or optimizing your resources for family and future investments.

TIMING ASSET TRANSACTIONS

The timing of when you realize capital gains can significantly impact your tax liability. By strategically planning asset sales, you can optimize tax outcomes and enhance your financial position.

Here’s how:

• Income management: Selling assets during years when your taxable income is lower may result in a reduced tax rate on capital gains.
• Long-term planning: Holding investments for longer periods may align with federal benefits for long-term capital gains, although California's state taxes remain the same.
• Avoiding tax spikes: Spreading out the sale of large assets over multiple years can prevent a substantial increase in taxable income in a single year.

Strategies to manage the timing of asset sales include:

• Installment sales: Receiving payments over time can spread out capital gains, potentially keeping you in a lower tax bracket.
• Charitable contributions: Donating appreciated assets can provide tax deductions while supporting causes you care about.
• Like-kind exchanges: Although limited, certain exchanges can defer capital gains taxes.

THE IMPORTANCE OF PROFESSIONAL FINANCIAL ADVICE

Navigating the complexities of capital gains tax requires more than just knowledge – it demands

strategic planning and professional insight. Financial advisors play a pivotal role in helping you manage capital gains tax liabilities, helping ensure that your investment decisions align with both your short-term needs and long-term goals.

A Financial Advisor’s Role in Managing Tax Liabilities

Financial advisors bring a wealth of expertise to the table, particularly in tax planning and investment

strategies. They can help you:

• Optimize your investment portfolio: By aligning your investments with tax-efficient strategies, advisors can help you design a portfolio that seeks to enhance your after-tax returns.
• Implement tax-reduction strategies: Advisors are well-versed in techniques like tax-loss harvesting and can identify opportunities you might overlook.
• Stay updated on tax laws: Tax regulations are constantly evolving. Advisors keep on top of changes that could impact your investments and help adjust your strategies accordingly.
• Coordinate with tax professionals: Advisors often collaborate with tax attorneys or certified public accountants to provide comprehensive support.

Every individual's financial situation is unique. Personalized guidance helps ensure that strategies are tailored to your specific circumstances.

EMPOWER YOUR FINANCIAL FUTURE TODAY

Understanding and managing capital gains tax is not just a matter of compliance – it's a critical component of your financial success.  

But don't navigate these complexities alone. Edelman Financial Engines is here to provide personalized guidance and strategies tailored to your unique situation. Along with your qualified tax professional, our experienced financial planners can help you effectively manage capital gains tax planning to better understand your tax liability and empower you to take control of your financial future.

The California capital gains tax system is complex, but professional support can help you navigate it with confidence. Contact Edelman Financial Engines today to start a conversation about how we can help you tackle California's unique tax challenges and support your financial journey to help you keep more of what you've earned.