What California Does (That the Federal Government Does Not)

California does not conform to IRC § 1(h), the provision that creates preferential federal tax rates for long-term capital gains. Under California law, capital gains are taxed as ordinary income — full stop.

This is the fact that surprises most people. The federal preferential rate has existed in some form since the 1920s. It is embedded in financial planning assumptions, investment holding-period decisions, and most tax software’s default settings. When a planner says “long-term gains are taxed at 20%,” they are describing federal law. They are not describing California.

The policy reason is straightforward: California made a deliberate decision not to adopt the federal capital gains preference when it restructured its income tax code. The state taxes all income as income. There is no statutory distinction between a dollar of wages and a dollar of gain on a stock sale. The California Franchise Tax Board (FTB) collects accordingly.

Two other things California does not conform to that frequently cause planning problems:

• California does not conform to IRC § 1202 (Qualified Small Business Stock exclusion). A founder who excludes $10–$15 million of gain federally still pays California tax on the same gain at up to 13.3%. We cover this in the QSBS section below.
• California does not conform to IRC § 1400Z-2 (Opportunity Zones). The federal gain deferral from investing in a Qualified Opportunity Fund is federal-only. California taxes the deferred gain in the year the original sale occurs, not in the year the OZ deferral election is made. This eliminates most of the Opportunity Zone benefit for California residents on the state side.

California Capital Gains Tax Rates

California’s income tax rates run from 1% to 13.3%. Capital gains are taxed at the same rates. The top marginal rate of 13.3% applies to taxable income above $1,000,000.

The 13.3% rate is not a round number. It is the base rate of 12.3% plus a 1% Mental Health Services Tax surcharge on income over $1 million, enacted under Proposition 63 in 2004 and codified under R&TC § 17043. The surcharge applies to the entire amount of income over $1 million, including capital gain income. For a California resident with a $10 million gain, a substantial portion of that gain is taxed at 13.3%.

The full 2026 California income tax brackets for single filers:

Capital gain is added on top of ordinary income for the year. If you have $200,000 of ordinary income and you sell a business for a $3 million gain, the gain is stacked on top of the $200,000. The great majority of the $3 million falls in the upper brackets. For married filers, the bracket thresholds are double; for heads of household, they are at intermediate levels. R&TC § 17041 governs the bracket structure.

One planning implication: California’s bracket structure means that spreading a gain across multiple years can move significant dollars out of the 13.3% bracket and into lower brackets. An installment sale (discussed below) that takes a $3 million gain over five years might keep each year’s increment out of the 13.3% bracket entirely, depending on the taxpayer’s other income.

The Federal vs. California Gap: What It Means for Your Transaction

A California resident in the top federal bracket recognizes long-term capital gain at a combined rate of approximately 37.1% — 23.8% federal (20% LTCG + 3.8% NIIT) plus 13.3% California. There is no holding period that reduces the California portion.

For comparison: a Texas or Nevada resident with the same transaction profile pays 23.8% — the same federal rate with zero state tax. The California premium on a large transaction is 13.3 percentage points. On a $5 million gain, that is $665,000 in additional tax that the Texas resident does not pay.

This arithmetic explains why California residency planning before a liquidity event is a real, recurring conversation for high-net-worth taxpayers. It also explains why the FTB audits departures aggressively — they know what is at stake. (See our separate California exit tax page for how the FTB treats people who leave before a transaction.)

The practical issue for most California residents is not choosing whether to pay California tax — it is structuring transactions to minimize unnecessary bracket exposure. A taxpayer who takes a $10 million gain in a single calendar year has the entire amount stacked into the 13.3% bracket. The same taxpayer who uses an installment sale, a CRT, or a year-of-sale income-smoothing strategy might pay 9.3% or 10.3% on a portion of that gain instead.

The gap also creates distorted planning incentives. Federal benefits that are designed to reduce tax on capital gains — QSBS exclusion, Opportunity Zone deferral — do nothing for California. A founder who builds an exit strategy entirely around a federal §1202 exclusion may be unpleasantly surprised at the state return.

Planning Strategies That Actually Work in California

The goal of California capital gains planning is reducing the amount of gain that lands in the top brackets — either by spreading recognition over time, converting character, shifting the gain to a tax-exempt or tax-deferred vehicle, or eliminating recognition at death through stepped-up basis.

Installment Sales (IRC § 453)

An installment sale under IRC § 453 is the most broadly applicable California capital gains planning tool. California conforms to the federal installment sale rules under R&TC § 17024.5. Selling a business or property and receiving payments over multiple years allows the taxpayer to recognize gain in each year proportionally, spreading the income across multiple tax years and potentially across multiple tax brackets.

The mechanics: each payment received includes a return-of-basis component, an ordinary-income component (if the sale includes ordinary-income assets like depreciation recapture, receivables, or inventory), and a capital-gain component. Only the gain component is taxed as income. The ratio is determined by the gross profit percentage — gain divided by total selling price — applied to each payment received. Depreciation recapture (IRC § 1245 and § 1250 recapture) is recognized in the year of sale regardless of the installment structure, so recapture income cannot be deferred.

For a California taxpayer, a $5 million gain spread over five years at $1 million per year may result in each annual installment landing in the 9.3% or 10.3% bracket rather than the 13.3% bracket, depending on the taxpayer’s other income in each year. The overall California tax savings can be meaningful — though the taxpayer is also forgoing current use of the deferred proceeds, which has a time value cost. We model both the tax savings and the time-value cost before recommending this structure.

One risk to structure around: if the buyer is a related party, the installment sale rules impose restrictions under IRC § 453(e) and § 453(g). If the installment obligation is pledged as security for a loan, the pledge can trigger immediate recognition. We review the entire note structure before the sale closes.

Charitable Remainder Trust (CRT)

A Charitable Remainder Trust allows a taxpayer to contribute a highly appreciated asset to the trust before the sale, sell within the trust, avoid immediate recognition of the gain, receive an income stream from the trust for years or life, and take a partial charitable deduction at contribution.

The CRT is a tax-exempt entity under IRC § 501(a). When the trust sells the appreciated asset, it pays no tax on the gain. The trust then distributes the proceeds as income to the beneficiary (the donor) over the trust term. Each distribution carries out the gain — so the tax is not eliminated, it is deferred over the distribution period. California conforms to the federal CRT rules, and California taxes the California-source distributions as ordinary income when received. The benefit is deferral, income smoothing, and the charitable deduction.

The CRT is most effective when: (1) the taxpayer has a highly appreciated, low-basis asset; (2) the taxpayer wants an income stream rather than a lump sum; and (3) the taxpayer has genuine charitable intent for the trust remainder. A CRT designed purely to avoid tax with a placeholder charity typically does not survive scrutiny.

Step-Up Basis Planning (“Swap Till You Drop”)

California conforms to IRC § 1014, the stepped-up basis at death rule. California community property law takes this further: both halves of community property receive a full step-up when either spouse dies.

Under IRC § 1014, property included in a decedent’s gross estate receives a basis equal to fair market value at date of death. For a California married couple holding community property, both the decedent’s half and the surviving spouse’s half step up to date-of-death value. In a common-law state, only the decedent’s half steps up; the surviving spouse’s half keeps its historical basis. This makes California community property uniquely powerful for “swap till you drop” real estate planning — holding appreciated investment property until death rather than selling, deferring gain recognition indefinitely, and allowing the heirs to inherit property at stepped-up basis with no gain to recognize on a subsequent sale.

For real property held in a 1031 exchange chain, the strategy is to continue exchanging until death, at which point the stepped-up basis eliminates the accumulated deferred gain permanently. California conforms to 1031 for this purpose (with the Form 3840 clawback issue discussed below), so the exchange chain is preserved on the California return as well.

Opportunity Zones — Federal Only

California does not conform to IRC § 1400Z-2. A California resident who invests capital gains in a Qualified Opportunity Fund (QOF) defers the federal gain but still recognizes the gain for California purposes in the year of sale.

This is a common planning misunderstanding. The QOF deferral that appears on the federal return — reporting the gain as deferred under Schedule D — does not carry over to the California return. The FTB requires the gain to be reported and taxed in the year of the original sale. For California residents, the Opportunity Zone benefit is partially eroded by the state tax that is due immediately even as the federal tax is deferred. Whether this makes an OZ investment worthwhile depends on the specific fund, the expected appreciation, and the taxpayer’s California tax bracket analysis. We run this comparison specifically before an OZ investment is made.

QSBS and the California Problem

California does not conform to IRC § 1202, the Qualified Small Business Stock exclusion. A founder who excludes $10–$15 million of gain from federal tax under § 1202 still owes California tax on the same gain at up to 13.3%.

This is the most consequential California non-conformity for startup founders. Section 1202 allows the original holder of qualifying C-corporation stock to exclude up to $10 million per issuer (or 10 times adjusted basis) from federal capital gain — or $15 million for stock acquired after the One Big Beautiful Bill Act effective date. The exclusion is 100% for stock acquired after September 27, 2010 and held more than five years. The result at the federal level is zero capital gains tax, zero Net Investment Income Tax, and no AMT preference on qualifying gain.

California excludes nothing. The full gain is reported and taxed on the California return at ordinary income rates. For a California-resident founder selling $10 million in qualifying QSBS, the federal bill is approximately zero; the California bill is approximately $1.33 million (at 13.3% on the full amount). That is a real number, and any planning that does not account for it is incomplete.

We cover the § 1202 qualification requirements, stacking strategies, and the California exposure in detail on our QSBS § 1202 attorney page. The short version: § 1202 planning must be designed with the California non-conformity in mind from day one. Strategies that maximize the federal exclusion without accounting for California liability are not complete plans — they are partial plans with a $1.3M blind spot.

1031 Exchange and the FTB Clawback

California conforms to IRC § 1031 like-kind exchange treatment for real property — but with an important catch. If you exchange California real property for out-of-state replacement property, the FTB retains a continuing claim on the original California gain under Form 3840.

The mechanics: you sell California rental property, defer the gain into a Texas replacement property under § 1031, and report the exchange on your California return. California allows the deferral — no California tax is due in the year of the exchange. But California requires you to file Form 3840 each year you hold the out-of-state replacement property, reporting the original deferred California gain. When you eventually sell the replacement property, California taxes the original deferred gain from the California property, even if you no longer live in California at the time of the second sale.

This is the FTB clawback trap. For taxpayers planning to exit California real estate into out-of-state property as part of a broader relocation strategy, the clawback means the deferred California gain follows them — it is not left behind when they leave the state. The only clean exits are (1) continuing to exchange into California replacement property, which keeps the gain deferred and avoids Form 3840 filing altogether; (2) holding the out-of-state property until death, at which point stepped-up basis eliminates the deferred gain; or (3) accepting that the deferred California gain will eventually be taxed when the replacement property is sold.

For most real property investors, a 1031 exchange is still the right tool for deferral — including exchanges into out-of-state property. The Form 3840 obligation is manageable; the clawback is not a reason to avoid exchanges. But it needs to be accounted for in the planning. We cover the full 1031 mechanics, QI selection, reverse exchanges, and California-specific issues on our 1031 exchange attorney page.

Residency Planning Before a Sale — The Risk/Reward

Changing California domicile before a liquidity event is a real planning option. It is also one the FTB audits aggressively, and it only works if you actually change your domicile — not if you count days and stay in a hotel in Nevada for three months.

The theory: if you genuinely establish domicile in a state with no income tax (Nevada, Texas, Washington, Florida) before the sale, the capital gain is sourced to your new state and California has no claim on it. California source-income rules under R&TC § 17951 tax California-source income even for non-residents, but a gain on the sale of a closely-held business or stock is not California-source income if the taxpayer is domiciled outside California when the sale occurs. For a business sale or stock transaction, the gain follows the taxpayer’s domicile — not the location of the business.

The reality: the FTB has a specialized audit unit that reviews part-year and non-resident returns from high-income taxpayers who left California within one to two years of a major liquidity event. The FTB’s nine domicile factors (discussed in detail on our California exit tax page) are scrutinized for evidence that the departure was genuine versus tax-motivated and incomplete. A person who claims Nevada domicile but maintains a California home, sees California doctors, belongs to California clubs, and has their family in California will have a difficult audit.

The risk/reward: the savings on a $10 million gain are approximately $1.33 million. Whether that justifies the cost, disruption, and audit risk of a genuine domicile change depends on the individual’s circumstances. People who were already planning to relocate and have a pending liquidity event should accelerate the timeline and get the move done right. People who are not genuinely relocating should not do this — a failed residency change that triggers an FTB audit, interest, and penalties is worse than paying the tax from California.

Residency planning requires contemporaneous documentation: a new driver’s license in the new state, voter registration, bank accounts, the sale or rental of the California home, changed social connections. The burden of proof is on the taxpayer. We help clients who are genuinely relocating build and document the case.

How Brotman Law Helps

California capital gains planning is transaction-specific. The right answer depends on the type of asset being sold, the taxpayer’s other income, timing constraints, charitable objectives, and whether residency change is a realistic option.

We work with business owners, founders, real estate investors, and high-net-worth individuals who have a pending or anticipated liquidity event and want to understand what California is going to take — and what, realistically, can be done about it. That starts with running the actual numbers: what does the California tax look like under the default scenario, and what does it look like under each planning alternative?

We are direct about what works and what does not. Installment sales, CRTs, and 1031 exchanges are real tools with real limitations. The § 1202 exclusion saves federal tax and nothing on the California return. Opportunity Zone deferral does not apply in California. Residency changes work when they are real and documented, and they do not work when they are not.

If you have a transaction coming up and want to understand the California exposure and your options, book a free 15-minute call. We can usually give you a useful directional answer in that conversation. If the planning requires more depth, we outline what that looks like and what it costs. See also our tax advisory and opinion letter page for more formal transaction review engagements.