Home Sale Capital Gains Exclusion

The home sale exclusion, IRC Section 121, removes up to $250,000 of gain from the sale of a primary residence for a single filer and $500,000 for married filing jointly, per the IRS. The gain is sale price minus basis, where basis is purchase price plus qualifying improvements minus depreciation taken. The exclusion is not a deduction; it erases the gain entirely, and it can be used once every two years.

The gate is the ownership-and-use test: you must have owned and lived in the home as a primary residence for two of the five years before the sale. The two years need not be consecutive. For the $500,000 joint exclusion, one spouse must meet the ownership test and both must meet the use test. Depreciation claimed on a rented portion is recaptured at up to 25% and never excluded, and the exclusion does not apply to a second home or a pure rental.

The arithmetic is sale price minus basis. Basis starts at the purchase price, adds capital improvements, a new roof, a remodel, an addition, and subtracts depreciation claimed on any rented portion. A couple buys at $300,000, adds $80,000 of improvements, and sells at $520,000: the gain is $140,000, and the $500,000 joint exclusion erases all of it. The sale reports on Form 1099-S, and the return shows no tax when the exclusion covers the gain.

The ownership-and-use test runs on the five years before the closing date: two of owned and occupied as a primary residence, not necessarily consecutive. A homeowner who rents the house out for a year in the middle still qualifies; the test is a two-of-five tally, not a streak. The rental years carry the wrinkle: depreciation claimed is recaptured at a maximum 25% rate and never excluded, so a house rented for five years and sold still owes the recapture on every dollar of depreciation taken.

The exclusion repeats every two years, which is the feature most homeowners never use. Sell at a $200,000 gain, buy again, live two years, sell at another $200,000 gain: both are erased. The proration applies when the test is partially met for a job move or health reasons, per the IRS formula in Publication 523. Married filing separately halves the exclusion to $125,000 each.

The exclusion is the largest tax break most American households ever touch, and most sellers never think about it because the closing clears the gain automatically. The mortgage, the improvements, and the timing all feed the basis, and the basis is the number the exclusion works against. The two-year rule is the gate, and the rental recapture is the fine print.

I watched a colleague named Brent (yes, that Brent) rent his house for four years, sell at a $180,000 gain, and assume the exclusion covered everything. The four years of depreciation he had claimed, roughly $29,000, was recaptured at 25%, and the rest of the gain was erased by the two-of-five test. The surprise was the $7,250 recapture bill, not the gain.

The highest-leverage thing most Americans can do is track every capital improvement in a folder from the day of purchase, because basis is the number the exclusion multiplies. Run the arithmetic with the rent vs. buy calculator, check the mortgage side in the mortgage amortization entry, and price the gain with the US CGT calculator.