Income Tax and California Withholding on Real Estate Transactions

[Another Reader]

I sold a rental in California 2020 and the State of California withheld 3.33 percent of the gross purchase price. When I file, I will get most of it back. My question is about how this is treated for income tax purposes in 2020 and 2021. Is it a deduction for purposes of computing the gain for 2020? And is the refund then taxed as ordinary income for 2021? TIA!

 

[SecondCor521]

No, your gain is your selling price minus your basis, which I think will be your cost plus capital improvements plus any selling costs (RE commissions, etc.). You also have to deal with depreciation recapture at the federal level, but I've not looked at that in a while so I don't recall how that interacts with the capital gains rules. The withholding of state taxes on the sale shouldn't count as a cost of sale or otherwise add to your basis.

At the federal level, refunds of state income tax are only taxable if you itemized the previous year (in this case 2020) and took a deduction for state income taxes paid. Refer to the instructions for IRS Schedule 1, line 1.

 

[Another Reader]

No, your gain is your selling price minus your basis, which I think will be your cost plus capital improvements plus any selling costs (RE commissions, etc.). You also have to deal with depreciation recapture at the federal level, but I've not looked at that in a while so I don't recall how that interacts with the capital gains rules. The withholding of state taxes on the sale shouldn't count as a cost of sale or otherwise add to your basis.

At the federal level, refunds of state income tax are only taxable if you itemized the previous year (in this case 2020) and took a deduction for state income taxes paid. Refer to the instructions for IRS Schedule 1, line 1.

This is not a basis or cost of sale question. This is a tax payment question.
California withheld substantially more than than I will actually owe for 2020. I itemize every year because of the rentals and my mortgage. When I itemize, the tax paid to California will likely be deducted as an expense. Let's say they overwithheld $20,000. I will get that back when I file for 2020 in 2021. The refund will be taxable in 2021 as I understand it. Is my understanding correct?

 

[jkern]

This is not a basis or cost of sale question. This is a tax payment question.
California withheld substantially more than than I will actually owe for 2020. I itemize every year because of the rentals and my mortgage. When I itemize, the tax paid to California will likely be deducted as a rental expense. Let's say they overwithheld $20,000. I will get that back when I file for 2020 in 2021. The refund will be taxable in 2021 as I understand it. Is my understanding correct?

State refunds are taxable to the extend that they were deducted from your taxable income on Schedule A. Because of the relatively new $10K cap for state tax and property tax, you likely deducted little to no state income tax on your return.

 

[Another Reader]

State refunds are taxable to the extend that they were deducted from your taxable income on Schedule A. Because of the relatively new $10K cap for state tax and property tax, you likely deducted little to no state income tax on your return.

If I understand you, I will therefore not pay much tax if any on the large refund I will get from the state when I file for 2020. Correct?

 

[jkern]

If I understand you, I will therefore not pay much tax if any on the large refund I will get from the state when I file for 2020. Correct?

That is correct. There are worksheets that will allow you to calculate the taxability of your state refund.

 

[SecondCor521]

This is not a basis or cost of sale question.

OK. Then I don't understand why you wrote this in the OP, unless you're using the word "gain" in an odd way:

Is it a deduction for purposes of computing the gain for 2020?

This is a tax payment question.
California withheld substantially more than than I will actually owe for 2020. I itemize every year because of the rentals and my mortgage. When I itemize, the tax paid to California will likely be deducted as an expense. Let's say they overwithheld $20,000. I will get that back when I file for 2020 in 2021. The refund will be taxable in 2021 as I understand it. Is my understanding correct?

Yes, generally speaking, it will be taxable at the federal level. You can confirm your understanding by reading the instructions for Form 1040 Schedule 1 Line 1. There is a worksheet that you or your tax software should complete. This year it's on page 86.