California Treats Capital Gains as Ordinary Income

Most states with an income tax follow the federal distinction between short-term and long-term capital gains. California doesn’t. The Franchise Tax Board (FTB) treats all capital gains — whether you held the asset for two months or twenty years — as ordinary income on your Form 540. That’s the single biggest difference between California and nearly every other state.

What this means in practice: a W-2 employee earning $300,000 who sells stock for a $200,000 long-term gain will pay federal tax on that gain at 15% (or 20% if total income pushes past $518,900 for single filers per IRC Section 1(h)). But California will stack that $200,000 on top of the $300,000 salary and tax the combined amount at marginal rates up to 12.3% — plus an additional 1% Mental Health Services Tax if the total exceeds $1 million.

That 1% surcharge is easy to overlook. It was introduced by Proposition 63 in 2004, and it applies to all taxable income above $1,000,000, not just capital gains. But a large asset sale is usually what pushes someone over the threshold.

California’s Income Tax Rate Schedule

For 2025, California’s marginal rates for single filers look like this:

• 1% on income up to $10,756
• 2% on $10,757 – $25,499
• 4% on $25,500 – $40,245
• 6% on $40,246 – $55,866
• 8% on $55,867 – $70,612
• 9.3% on $70,613 – $360,659
• 10.3% on $360,660 – $432,787
• 11.3% on $432,788 – $721,314
• 12.3% on $721,315 and above
• 13.3% (12.3% + 1% Mental Health Services Tax) on income over $1,000,000

Married filing jointly brackets are roughly double. The point here isn’t memorizing brackets — it’s understanding that capital gains income slots directly into this schedule, stacked on top of your wages, business income, rental income, and everything else. There’s no separate, lower rate. See our CA Form 540 tax rates page for the full schedule.

The Mental Health Services Tax on Gains Over $1 Million

Worth its own section because we see clients caught off guard by it every year. If your total California taxable income — including capital gains — exceeds $1,000,000, you owe an extra 1% on the amount above that threshold. That’s $1,000,000 in a single tax year, not cumulative. Read more on our Mental Health Services Tax page.

Selling a house you’ve owned for 30 years in the Bay Area? That gain alone might clear the $1M line. A concentrated stock position vesting at IPO? Same story. The extra 1% sounds small until you realize it’s $10,000 on every million above the threshold, on top of the 12.3% rate you’re already paying.

The Primary Residence Exclusion Still Applies

Good news: the federal exclusion under IRC Section 121 carries through to your California return. If you sell your primary residence and meet the ownership and use tests (owned and lived in the home for at least 2 of the last 5 years), you can exclude up to $250,000 of gain as a single filer or $500,000 if married filing jointly.

This exclusion applies for both federal and California purposes. So a married couple selling their home for a $450,000 gain pays zero federal capital gains tax and zero California tax on that gain. But if the gain exceeds $500,000 — and in San Francisco, Los Angeles, or San Jose, that’s increasingly common — the excess is taxed as ordinary income at state level. See our home sale tax rules page for more.

One thing people forget: the exclusion doesn’t apply to the depreciation you claimed (or should have claimed) if you rented the property at any point. That depreciation recapture hits you at 25% federally and as ordinary income in California.

Installment Sales: Spreading the Gain Across Years

If you’re selling a business, real estate, or another large asset, structuring the transaction as an installment sale under IRC Section 453 lets you recognize gain as you receive payments rather than all at once. California conforms to the federal installment sale rules.

Why does this matter? Because California’s 13.3% top rate kicks in at income over $1M. If you can spread a $3 million gain across three tax years instead of recognizing it all in one, you might keep each year’s income below the Mental Health Services Tax threshold — or at least reduce the amount subject to the highest brackets.

There are trade-offs. You take on credit risk from the buyer. You defer your cash. And interest on the deferred payments is taxable income too. But for the right situation, installment sales remain one of the most straightforward ways to manage a large California capital gains bill.

Moving Out of State Before Selling — and Residency Audit Risk

This is the strategy everyone asks about: relocate to Nevada, Texas, Florida, or another zero-income-tax state before selling the asset. On paper, it works. California taxes residents on worldwide income, but non-residents only on California-source income. If you move to Nevada and then sell stock in a Delaware corporation, that gain isn’t California-source.

Here’s the catch. The FTB is aggressive — more aggressive than almost any other state — about residency audits. They look at where your spouse lives, where your kids go to school, where your doctors and dentists are, where your car is registered, which state issued your driver’s license, and how many days you spent in California after claiming to leave. They’ll pull cell phone records and credit card statements.

A half-hearted move doesn’t cut it. If you rent a place in Reno but your family stays in Palo Alto and you fly back every weekend, the FTB will argue you never left. The burden of proof is on you to show you established domicile in the new state. We’ve seen clients who moved “on paper” get hit with back taxes, penalties, and interest after a two-year audit. The savings need to justify a genuine, full relocation — not a mailbox and a lease.

There’s also a clawback risk for certain types of deferred compensation. California can tax stock options and RSUs based on where you worked when the compensation was earned, even if you’ve since moved. The sourcing rules are complex and fact-specific.

Qualified Opportunity Zone Deferrals

Federal Qualified Opportunity Zone (QOZ) investments let you defer capital gains by reinvesting them into a Qualified Opportunity Fund within 180 days of the sale. California partially conforms. The state allows the deferral of gain, but the rules have quirks — California didn’t adopt the step-up in basis that the original federal legislation provided for investments held 5 or 7 years (those federal provisions expired in 2026 anyway for most taxpayers).

The QOZ deferral is a timing tool, not a permanent exclusion. The deferred gain comes back into income on December 31, 2026, or when you sell the QOZ investment, whichever is earlier. If you’re still a California resident at that point, you’ll pay California tax on the recognized gain. Moving out of state before the recognition date is one planning angle, but see the residency audit discussion above.

Timing Strategies Worth Considering

Beyond installment sales and relocation, a few other timing-based approaches can reduce your California capital gains exposure:

• Harvest losses in the same year. Capital losses offset capital gains dollar-for-dollar on both your federal and California returns. If you’re sitting on losing positions, selling them in the same year as a large gain reduces the net amount subject to tax. See our tax-loss harvesting guide.
• Bunch income into alternating years. If you have control over when gains are recognized (selling rental property, exercising options), try to avoid stacking multiple large gains in a single year. Two $500K gains in two separate years cost less in California tax than one $1M gain in a single year because of the Mental Health Services Tax.
• Use a 1031 exchange for real estate. California conforms to IRC Section 1031 like-kind exchanges for real property. Swapping one investment property for another defers the gain entirely — no California tax until you eventually sell without exchanging.
• Charitable remainder trusts. Contributing appreciated assets to a CRT before sale can spread the gain recognition over the trust’s term while generating a charitable deduction. This works for both federal and California purposes, but the economics only make sense for larger positions (usually $1M+).

What About the Federal Side?

California’s treatment stacks on top of federal capital gains taxes. A high-income California resident selling long-term capital gains could face a combined rate of 20% (federal long-term rate) + 3.8% (Net Investment Income Tax) + 13.3% (California) = 37.1%. That’s a real number. Short-term gains are worse: up to 37% federal + 3.8% NIIT + 13.3% California = 54.1%.

The federal long-term rate is 0% for taxable income up to about $47,025 (single) or $94,050 (married filing jointly) in 2025, 15% for most filers above that, and 20% once taxable income exceeds $518,900 (single) or $583,750 (MFJ) per IRC Section 1(h). But none of those preferential rates exist on the California side. The state treats it all the same regardless of holding period.

One planning note: if you’re subject to the Alternative Minimum Tax (AMT) federally, the interaction with California capital gains adds another layer. California has its own AMT with different exemption amounts and rates. Work through both calculations before making a sale — or better yet, have your tax advisor model the numbers.

Sources & References

• IRC Section 1(h) — Federal Capital Gains Tax Rates
• IRC Section 121 — Exclusion of Gain From Sale of Principal Residence
• IRC Section 453 — Installment Method
• IRC Section 1031 — Like-Kind Exchanges
• California FTB — 2024 Form 540 Tax Rate Schedules
• California FTB — Residency Status and Audit Guidelines
• IRS Tax Topic 409 — Capital Gains and Losses