Prop 13 & Depreciation Recapture: California Rental Exit Math

Prop 13 Is a Property Tax Story

Prop 13 limits how fast your assessed value can rise for property tax purposes — roughly 2% a year — which means a rental bought in San Jose in 1995 has been taxed on a fraction of its market value ever since. That’s real money saved, year after year.

But property tax is a tax on owning. The moment you sell, a completely different tax regime takes over: income tax on the gain. Prop 13 has no jurisdiction there. Neither does the low assessed value — in fact, the gap between your Prop 13 assessed value and the sale price is a rough preview of how large your taxable gain is.

The Three Layers of the Exit Bill

On a long-held California rental, the sale triggers three federal layers plus the state:

1. Unrecaptured Section 1250 gain — taxed at a maximum 25% federal rate.Depreciation you claimed (or were entitled to claim) over the years is recaptured as unrecaptured Section 1250 gain, taxed at a maximum 25% federal rate. On a property held 20+ years, this is frequently the biggest single line on the bill — and the one owners most underestimate.
2. Federal capital gains — 15% or 20%.On the remaining gain, depending on your bracket, plus the 3.8% net investment income tax for higher earners.
3. California — up to 13.3%.California taxes capital gains as ordinary income. There is no preferential rate. A gain that faces 15% federally can face 13.3% from the state on top.

Add them up on a property with a few hundred thousand dollars of gain and decades of depreciation, and the combined bill routinely shocks owners who were only thinking about “capital gains.”

What a 1031 Exchange Does — and Doesn’t — Do Here

A 1031 exchange defers all of it: the recapture, the federal gain, the California gain. It makes none of it disappear. And the California portion comes with a string attached: the Franchise Tax Board generally requires Form 3840 every year until the deferred gain is recognized. The recapture you deferred in 2026 is still recapture when the deferral ends in 2036 — it just waits its turn. Replacement property can be direct real estate or a Delaware Statutory Trust interest — the DST guide walks through how that structure works inside an exchange.

This is the math to run before deciding between exchanging, selling outright, or holding. Each path treats the three layers differently, and the right answer depends on your bracket, your timeline, and your heirs. Start with a rough number from the capital gains tax calculator. For the interstate version of this move, see the California-to-Texas exchange guide.

The Heir Question

One more layer belongs in the comparison: for older landlords, holding until death can give heirs a step-up in basis — resetting the property’s basis to its date-of-death value and removing the embedded gain, including the unrecaptured Section 1250 portion, for income tax purposes. Against a combined federal-plus-California exit bill that can exceed 40% of the gain in the top brackets, “don’t sell” is sometimes the better strategy — though it means your heirs inherit a management burden, not a plan. It deserves a seat at the table alongside every exchange structure.

Prop 19 changed the inheritance math. Since February 2021, California’s Proposition 19 generally limits the parent-to-child property tax exclusion to a primary residence the heir actually lives in — an inherited rental is reassessed to market value. The old plan of passing the Prop 13 basis to the kids along with the building no longer works for investment property. That makes the hold-until-death vs. exchange comparison a live question, not a default: heirs may get the income-tax step-up but lose the property-tax shield in the same transfer. Model both sides before assuming the estate plan you wrote in 2015 still works. Weighing exchange, hold, or selling outright? Compare every exit path side by side, or see all landlord exit options.

Call Johnny Borrelli, Investment Adviser Representative: +1 (214) 203-9192. A first conversation runs your actual numbers — gain, recapture, California exposure, and the exchange-vs-hold comparison — before you list.

Frequently Asked Questions

Does Prop 13 protect me from taxes when I sell California rental property?

Prop 13 limits property tax reassessment while you own the property. It does nothing for income tax on the sale — federal capital gains, California's up-to-13.3% tax on the gain, and depreciation recapture all still apply.

How is depreciation recapture taxed on a California rental sale?

Depreciation you claimed is taxed as unrecaptured Section 1250 gain, taxed at a maximum 25% federal rate. California then taxes the gain as ordinary income at rates up to 13.3%. On a long-held rental, recapture is often the largest single line of the tax bill.

If I 1031 exchange out of California, does the recapture go away?

No — a 1031 exchange defers recapture along with the rest of the gain; it doesn't erase it. And California tracks the deferred gain with annual Form 3840 filings until it's recognized. The recapture comes due whenever the deferral ends.

This page is for educational purposes only and does not constitute tax, legal, or investment advice. Tax calculations are fact-specific; consult your CPA and tax attorney. Johnny Borrelli is a Registered Representative of Crescent Securities Group, member FINRA/SIPC, and an Investment Adviser Representative of Crescent Advisor Group, an SEC-registered investment adviser. CRD #6788697.

Disclosure: Johnny Borrelli is a Registered Representative of Crescent Securities Group and may receive compensation — including selling commissions — if you invest in a securities product through him. Ask for his Form CRS for details on how he is compensated.