Capital Gains Tax on Real Estate: What It Actually Costs and 5 Ways to Reduce or Defer It

If you have owned property for more than a few years here on California's Central Coast, the equity sitting in that property can come with a bigger tax bill than most owners expect. Between federal capital gains tax, California's state income tax, depreciation recapture, and the Net Investment Income Tax, a seller can lose a third or more of their gain to taxes on a single transaction.

The good news: there are several legal, well-established strategies for reducing, deferring, or in some cases eliminating that tax bill entirely. This guide walks through what capital gains tax is, what it typically costs a California seller, and five strategies real estate investors use most often, each one linked to the official IRS source so you can verify it yourself or bring it to your CPA.

What Is Capital Gains Tax?

Capital gains tax is the tax owed on the profit from selling an asset, including real estate, for more than your adjusted basis (generally what you paid, plus capital improvements, minus any depreciation you have claimed). The IRS defines this in Topic 409, and it draws a sharp line between two categories:

• Short-term capital gains: profit on property held one year or less, taxed at your ordinary federal income tax rate, which can run as high as 37%.
• Long-term capital gains: profit on property held more than one year, taxed at the preferential federal rates of 0%, 15%, or 20%.

For rental and investment property, there is a third piece most sellers underestimate: depreciation recapture. If you claimed depreciation deductions while you owned the property, that portion of your gain is taxed separately, at a federal rate of up to 25%, regardless of how long you held the property.

How Much Does Capital Gains Tax Actually Cost in 2026?

Here is the full stack of taxes that can apply to a real estate sale in California, using the 2026 federal brackets:

On top of the federal rate, layer in:

• Net Investment Income Tax (NIIT): an additional 3.8% federal tax that applies to capital gains once your modified adjusted gross income exceeds $200,000 single or $250,000 married filing jointly. See IRS Topic 559.
• California state tax: California has no separate capital gains rate. Every dollar of gain is taxed as ordinary income on the same schedule as wages, with a top marginal rate of 13.3% (which includes the 1% Mental Health Services Act surcharge) once taxable income exceeds $1,000,000. See the California Franchise Tax Board.
• Depreciation recapture: up to 25% federal on the portion of your gain tied to depreciation you have already deducted, taxed as ordinary income at the state level.

Add it together, and a California seller in a high tax bracket can realistically lose 35% to 40% of their gain to combined federal and state taxes on a single sale. That is the number that makes planning worthwhile.

A Real-World Example: What a Sale Actually Nets You

Here is a simplified, composite example (not an actual client or property) that shows how this plays out on a long-held Central Coast multifamily property.

That gap between net proceeds and net after tax is exactly what the strategies below are built to close.

5 Ways to Reduce or Defer Capital Gains Tax

1. The Section 121 Exclusion: Move In for 2 of the Last 5 Years

IRC Section 121 lets you exclude up to $250,000 of gain (single) or $500,000 (married filing jointly) when you sell your primary residence, as long as you owned and lived in it for at least 24 months out of the 5 years before the sale. See IRS Topic 701.

This is why some investors will move into a long-term rental for two years before selling it. It can work, with two important caveats:

• Depreciation recapture is not excluded: any depreciation you claimed while it was a rental remains taxable, even on an otherwise excluded gain.
• Nonqualified use applies: gain is prorated between the years the property was a rental and the years it was your primary residence. The exclusion only applies to the personal-use portion.

Best for: owners who are willing to occupy the property and have a gain modest enough that the exclusion meaningfully covers it.

2. The 1031 Exchange: Defer by Reinvesting in Like-Kind Property

A 1031 exchange lets you sell investment or business property and roll the full proceeds into a new like-kind property without recognizing the gain at the time of sale, deferring both the capital gain and the depreciation recapture. The rules, straight from the IRS like-kind exchange fact sheet and the Form 8824 instructions:

• 45-day identification window: you must identify your replacement property in writing within 45 days of closing the sale.
• 180-day completion window: the exchange must close within 180 days of the original sale, or by your tax return due date, whichever comes first.
• Qualified Intermediary required: you cannot touch the proceeds yourself. A QI must be in place before the original sale closes.
• Like-kind, broadly defined: any real property held for investment or business use generally qualifies as like-kind to any other.

Best for: owners who want to keep growing equity in real estate, upgrade to a larger or better-performing asset, or consolidate several properties into one.

3. The Delaware Statutory Trust (DST): A Hands-Off Way to Complete a 1031

A DST is a passive, professionally managed real estate trust that the IRS confirmed can qualify as replacement property in a 1031 exchange under Revenue Ruling 2004-86. You own a fractional interest in an institutional-grade asset, such as an apartment community or medical office building, and receive distributions without any landlord responsibilities.

DSTs also solve a real timing problem: finding and closing on a suitable replacement property within 45 days is one of the hardest parts of a 1031 exchange, and DST sponsors typically offer pre-packaged, ready-to-close options.

Two things to know before considering one:

• Operational restrictions apply: the trustee cannot raise new capital, refinance debt, or reinvest sale proceeds. These rules protect the 1031 qualification, but they also limit flexibility.
• DST interests are securities: they are illiquid, not publicly traded, and carry investment risk like any real estate offering. This is a conversation for your financial advisor, not just your CPA.

Best for: owners who want to exit active property management entirely while keeping their 1031 tax deferral intact.

4. The Installment Sale: Become the Bank and Spread Out the Tax

In an installment sale, you carry some or all of the financing yourself rather than receiving the full price at closing. Instead of recognizing the entire gain in one year, you generally recognize it in proportion to the principal payments you receive over the life of the note, reported each year on IRS Form 6252 under the rules in IRS Publication 537.

For example, on a $1,600,000 sale with $600,000 down and a $1,000,000 note at 5% over 25 years, the seller receives roughly $5,846 a month in principal and interest, fully passive, with no tenants or maintenance calls, and pays tax on the capital gains portion gradually as principal comes in.

The one piece that cannot be deferred: under IRC Section 453(i), depreciation recapture must be recognized in full in the year of sale, regardless of how the principal is collected. Only the capital gain portion spreads.

Best for: owners who want predictable, passive monthly income, are comfortable acting as the lender, and want a smaller tax bill in the year of sale rather than a deferral strategy tied to buying more real estate.

5. The Straight Sale: Sometimes Simple Is the Right Answer

A conventional sale is not a tax strategy, but it deserves a place on this list because it is sometimes the correct choice. You close, you receive the full proceeds, and the entire tax bill is due for that year. There is no note to manage, no replacement property to find, and no deadlines to track. For owners who want full liquidity now, a simple estate, or who plan to give away or spend the proceeds rather than reinvest, the straight sale's certainty can outweigh the tax cost.

Comparing Your Options

Frequently Asked Questions

Do I have to pay capital gains tax if I reinvest the proceeds in another property?

Only if you structure it as a 1031 exchange before you close on the original sale. Simply using the proceeds to buy another property without a Qualified Intermediary and the required deadlines does not defer the tax.

Does the Section 121 exclusion apply to rental or investment property?

Only if the property becomes your primary residence and you meet the 2-of-5-year ownership and use tests. Pure rental or investment property does not qualify on its own.

What happens to capital gains tax if I pass the property to my heirs instead of selling?

Property passed at death generally receives a step-up in basis to fair market value, which can eliminate the capital gain your heirs would otherwise owe if they sell soon after. This is a separate estate planning conversation worth having with your CPA and attorney.

Can I do a partial 1031 exchange and take some cash out?

Yes, but any cash or non-like-kind property you receive, known as boot, is taxable in the year of the exchange even if the rest of the transaction qualifies for deferral.

Which Strategy Is Right for You?

There is no universally correct answer here. The right strategy depends on your basis, your income in the year of sale, whether you want to stay invested in real estate, and how much passive income versus liquidity matters to you. What we can tell you is that all of these are real, IRS-recognized options, and the numbers change meaningfully depending on which one you choose. The earlier you start modeling this with your real estate team, CPA, and financial advisor, the more options stay open to you. A 1031 exchange in particular has to be set up before your sale closes, not after.

Sources and Further Reading

• IRS Topic 409, Capital Gains and Losses
• IRS Topic 701, Sale of Your Home
• IRS Topic 559, Net Investment Income Tax
• 26 U.S.C. Section 121, Exclusion of Gain from Sale of Principal Residence
• IRS Fact Sheet, Like-Kind Exchanges Under IRC Section 1031
• IRS Instructions for Form 8824, Like-Kind Exchanges
• IRS Revenue Ruling 2004-86, Delaware Statutory Trusts and Section 1031
• California Franchise Tax Board

This article is provided for general informational purposes only and does not constitute tax, legal, or investment advice. Tax laws change, and individual circumstances vary. Consult a licensed CPA, tax attorney, or financial advisor before making decisions about a property sale.