Understanding long-term capital gains tax in California

WHAT IS LONG-TERM CAPITAL GAINS TAX?

To understand your potential tax bill, you must first define what qualifies as a long-term capital gain. A capital gain occurs when you sell a capital asset – such as stocks, bonds or real estate – for more than its purchase price, also known as your cost basis.

For federal tax purposes, the Internal Revenue Service distinguishes between gains based on your holding period:

• Short-term capital gain: Realized on assets held for one year or less and taxed at your ordinary income tax rate
• Long-term capital gain: Realized on assets held for more than one year and taxed at preferential federal rates of 0%, 15% or 20%

Your specific tax rate depends on your taxable income and filing status. Additionally, high-income earners may be subject to a 3.8% net investment income tax. However, it’s vital to remember that California treats capital gains differently from federal rules, applying its own unique set of mandates.

HOW LONG-TERM CAPITAL GAINS TAX WORKS

Managing capital gains tax begins with understanding three key factors: how gains are calculated, how long you hold an asset and how your total income affects the tax rate you pay.

CALCULATING YOUR CAPITAL GAIN

Your tax liability starts with determining the gain on a sale. The basic formula is:

Capital gain = Sale price – cost basis

Your cost basis is generally the amount you paid to acquire the asset, including commissions and fees. It may also be adjusted for factors such as reinvested dividends, stock splits or capital improvements in real estate. 

For example, if you purchased a stock for $10,000 and later sold it for $15,000, your capital gain would be $5,000. This gain is the amount subject to capital gains tax.

If you sell an asset for less than its cost basis, you incur a capital loss. Losses may be used to offset capital gains and, in some cases, reduce taxable income.

THE HOLDING PERIOD

The length of time you own an asset determines the federal tax rate applied to the gain. As of the current tax year, assets held for 365 days or fewer result in a short-term capital gain. These are added to your other income, like wages, and taxed at your marginal income tax rate.

If you hold the asset for more than one year, the gain qualifies for long-term capital gains rates, which are generally lower. This timing distinction is a central element of capital gains tax planning for many investors.

TAXABLE INCOME AND CAPITAL GAINS RATES

Your long-term capital gains rate depends on your total taxable income and filing status. Capital gains are added to your other income, meaning a large gain could move you into a higher tax bracket.

Currently, most investors fall into the 15% rate, though some taxpayers with lower incomes qualify for a 0% rate, while the highest earners pay 20%.

This is particularly relevant for mid- to high-income earners who may already be near threshold levels for higher tax rates.

NET INVESTMENT INCOME TAX

In addition to standard capital gains tax rates, some taxpayers may also be subject to a 3.8% NIIT on investment income.

This surcharge typically applies to:

• Single filers with income above $200,000
• Married couples filing jointly with income above $250,000
• Married individuals filing separately with income above $125,000

Navigating tax laws requires looking at both the base rate and surcharges. Because this tax is applied on top of standard capital gains rates, it can significantly increase the total tax owed on investment income.

FEDERAL LONG-TERM CAPITAL GAINS TAX RATES

Federal long-term capital gains tax rates are designed to reward long-term investing and are generally lower than ordinary income tax rates. These rates apply only to the gain itself, not your total income.

The following table outlines the 2026 federal long-term capital gains tax rate brackets.

Most investors fall into the 15% long-term capital gains tax bracket, making it the most commonly applied rate. 

It’s also important to know:

• These thresholds are adjusted periodically for inflation
• Rates apply only to long-term capital gains, not wages or salaries
• Certain types of gains – such as collectibles or small business stock – may be taxed differently

Understanding where your income falls within these brackets can help inform decisions about when to realize gains and how to manage your investment portfolio.

HOW CALIFORNIA TAXES CAPITAL GAINS

In California, the tax structure for capital gains is integrated into the state's progressive income tax system. As a result, high-income earners may face a top marginal tax rate as high as 13.3% on a portion of their capital gains – the highest state tax rate in the country.     

Unlike the federal government, California does not offer preferential rates for long-term capital gains. Whether you hold a stock for two days or 10 years, the gain is taxed at the same ordinary income tax rate as your salary.

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

If you are managing high-value assets in the state, consulting with California financial advisors can help you model the impact of these rates on your net wealth.

FEDERAL VS. CALIFORNIA CAPITAL GAINS TAXES

Because California does not follow federal conventions for long-term gains, it is helpful to compare the two systems side-by-side.

While federal tax policy rewards long-term investing with lower rates, California's system taxes all capital gains as ordinary income. This means your state tax burden is often much higher than that of residents of states with either no income tax or that follow federal capital gains rules.

STRATEGIES FOR MINIMIZING CAPITAL GAINS TAX LIABILITY

Effective financial planning involves using wealth strategies that may 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 potentially not only reduces your federal 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 a gain elsewhere
• Maintain investment strategy: Reinvest the proceeds in assets that align with your goals but aren't “substantially identical,” to avoid IRS issues
• Mind the wash-sale rule: Avoid purchasing the same 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 provides a powerful tool that can potentially defer capital gains taxes. This provision allows you to sell an investment property and reinvest the proceeds into a like-kind property.

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 to help your real estate investments grow without the immediate tax impact, potentially preserving more capital for future opportunities.

USE TAX-ADVANTAGED ACCOUNTS STRATEGICALLY

Tax-advantaged accounts, such as 401ks or Roth IRAs, offer a smart way to help minimize the immediate tax impact of capital gains, though paying these taxes in taxable accounts isn't always a negative. 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 your retirement in California 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. A financial advisor plays 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, including estate planning.

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 you and your financial needs. Along with your qualified tax professional, our experienced financial advisors 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 in California today to start a conversation about how we can help you tackle the Golden State's distinct tax challenges and support your financial journey to help you keep more of what you've earned.