 How To Use The Tax-Free Home Sale Exclusion Every Two Years To Save |
Source |
American Shipper |
Post Date |
08/22/2025 |
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In Spring2025, I sold one of my properties and will successfully exclude $500,000 incapital gains, tax-free, thanks to the IRS Section 121 Exclusion. For thoseunfamiliar, this powerful rule allows homeowners to exclude up to $250,000 incapital gains if single, or $500,000 if married filing jointly, from the saleof a primary residence?s long as they meet the ownership and use tests.
Several monthslater, I?e just been notified by my tenant that they?e vacating one of myrental properties at the of their lease next month.
Given the SanFrancisco real estate market remains relatively strong, I? now faced with achoice: Do I sell the property and take advantage of favorable pricing? Or do Ihold onto it, boost my semi-passive income, knowing that if I wait until 2027, I could potentiallyexclude another $500,000 in capital gains?ax-free?
Let? walkthrough how the exclusion works, how often you can use it, and whyunderstanding this rule could save you six figures in taxes.
What Is the Section 121 Exclusion?
Under Section 121 of the IRScode, you can exclude up to$250,000 in capital gains ($500,000 if married filing jointly) from the sale ofyour primary residence, as long as:
1.
2. You?e owned the property for at least two out of the last five years, and
3.
4. You?e lived in the property as your primary residence for at least two out of the last five years.
5.
You can onlyuse this exclusion once every two years. If you sell anotherhome within two years of your last excluded gain, you cannot claim theexclusion again.
This ruledoesn? just apply to homes you?e always lived in. It can also be used onproperties that were previously rented out, if you meet the timingrequirements.
Why This Matters: My February 2025 Sale
In February2025, I sold a home I had lived in from 2020 to late 2023. I moved out andrented it for 12 months before prepping and selling. Because I had lived in itfor at least two of the past five years before the sale, I qualified for thefull $500,000 exclusion.
Let? say Ibought the home for $1,000,000 and sold it for $1,800,000.
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?Total capital gain: $800,000
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?Section 121 exclusion: $500,000
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?Depreciation recapture: $10,000 (taxed at 25%)
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?Remaining long-term capital gain: $300,000
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The $10,000 ofdepreciation recapture is not covered by the exclusion andwill be taxed at up to 25%, or $2,500. The remaining $300,000 in capital gainswill be taxed at long-term capital gains rates (typically 15%?0%, plus statetaxes and possibly the 3.8% NIIT). Were talking up to 33.8% in capital gainstax here in California!
Assuming I didzero remodeling, my total taxable gain is $315,000, split betweepreciation recapture and regular LTCG. Thats a painful ~$104,000 inlong-term capital gains taxes.
Still, I saved$150,000+ in taxes by taking advantage of the exclusion. To be specific:$500,000 X 33.8% = $169,000 in taxes I would have to pay if there was noexclusion! Even with prorating my capital gains, I get to use the fullexclusion amount.
The New Opportunity: Rental Property Tenant Gave Notice
Fast forwardto today. A tenant in one of my other rental properties just gave notice.They?e been there since January 2020, and I haven? lived in the propertysince. Lets say I bought the house in 2012 for $700,000 and is now worth $1.5million.
If I sell itnow, my capital gains would look something like this:
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?Sale price: $1,500,000
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?Original cost basis: $700,000
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?Improvements over the years: $50,000
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?Adjusted cost basis: $750,000
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?Depreciation taken over rental period (5 years): $100,000
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?Adjusted basis after depreciation: $650,000 ($750,000 cost basis minus depreciation)
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?Capital gain: $1,500,000 ?$650,000 = $850,000
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?Depreciation recapture (taxed at 25%): $100,000 = $25,000
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?Selling commission and transfer taxes: $80,000
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?Remaining gain: $670,000 (taxed at long-term cap gains rate)
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Because Ihaven? lived in the property for two of the past five years, I cannot take theSection 121 exclusion?t least not yet.
But what if Ileave my current ideal home for raising afamily and move back in tothis rental, which I called home from 2014-2019?
Moving Back In: The Two-Out-of-Five-Year Rule
To qualify forthe exclusion again, I need to:
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?Wait at least two years from my last use of the exclusion (February 2025 →February 2027), and
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?Live in the property as my primary residence for at least two years within the five-year window before selling.
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?Figure out the pro-rated amount I can exclude
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So, here? apossible game plan:
1.
2. September 2025: Tenant leaves. I move back in and make it my primary residence.
3.
4. February 2027: I become eligible to use the exclusion again, two years after the February 2025 sale of another home.
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6. September 2027: After two full years of living there, I meet the two-out-of-five-year use requirement again.
7.
8. Fall 2027: I sell and exclude $500,000 in gains?ax-free after calculating prorated capital gains.
9.
Let? look atthe revised tax math.
Selling in 2027 (Two Years Later) With Exclusion
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?Sale price: $1,550,000 (assuming modest $50,000 appreciation)
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?Adjusted basis: $650,000 ($750,000 original cost basis minus $100,000 depreciation taken over the years)
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?Total capital gain: $900,000 ($1,550,000 ?$650,000)
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?Prorated Section 121 exclusion:
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?I lived in the property as my primary residence for 8 of the 13 years I owned it.
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?That? 8 ?13 = 61.54% of the gain eligible for exclusion.
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?Eligible gain = $900,000 ?61.54% = $553,860 (eligible for exclusion, up to the $500,000 cap for married filing jointly).
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?Because the cap is $500,000, I can only exclude $500,000, but at least I get to exclude the full $500,000.
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?Ineligible gain due to non-qualified use: $900,000 ?$553,860 = $346,140 (taxable).
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?Depreciation recapture: $100,000 (taxed separately at up to 25% = $25,000 tax).
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?Selling commission and transfer taxes: $80,000 (reduces taxable gain).
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?Remaining capital gain subject to LTCG tax:
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?$346,140 ?$80,000 = $266,140 (taxed at my applicable long-term capital gains rate, plus NIIT if applicable).
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Do I reallywant to pay long-term capital gains tax on $266,140? Not really. Although I hadto pro-rate the exclusion amount, I still get to use the full $500,000 intax-free exclusion amount to save ~$169,000 in long-term capital gains taxes.The reason is because my pro-rated amount is still higher than the $500,000tax-free exclusion amount for married couples.
In otherwords, you can literally do the math to calculate when is the ideal time tosell your rental property to take 100% of the tax-free exclusion amount and notpay any long-term capital gains tax.
Moving back into the rental to unlock the tax free benefit before relocating to Honolulu feels like a financially prudent decision.
Another optionis doing a 1031 exchange to defer all taxesby reinvesting the proceeds into a rental property in Honolulu. But the idea oftaking on another rental and all the responsibilities that come with it feelsless appealing these days.
Prorated Exclusion If I Sell Early
What if Idecide to sell before September 2027?efore hitting the full two-year residencyagain?
There? alittle-known rule that allows for a partial exclusion if yousell early due to an unforeseen circumstance, job change, health issue, orother qualified reason. But it? tricky, and the IRS is strict aboutqualifying.
PartialExclusion = (Months of ownership and use / 24) ?$250,000 (or $500,000)
The safestmove is to wait the full 24 months before selling.
Just know thatyou must prorate the tax-free exclusion amount if you rented out the property after 2009 duringnon-qualifying years. The longer the property is used as a rental, the smallerthe tax-free exclusion you can claim.
Example Of Pro-Rating The Tax-Free Exclusion
Heres anotherexample below:
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?You bought a home in 2015.
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?You lived in it as your primary residence for 6 years (2015-2021).
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?Then you rented it out for 2 years (2021-2023).
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?You sold it in 2023 with a $600,000 gain.
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?You?e married filing jointly, so normally you? qualify for the $500K exclusion.
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But here? thecatch:
Because 2 ofthe 8 years of ownership (2019?022) were non-qualified use, you must proratethe exclusion:
Non-qualifieduse ratio = 2 years / 8 years = 25%
Gainineligible for exclusion: 25% ?$600,000 = $150,000
Gaineligible for exclusion: $600,000 ?$150,000 = $450,000
Since theeligible amount ($450,000) is under the $500,000 married-filing-jointly limit,you can exclude the full $450,000.
Taxablegain: $150,000 ($600,000 minus the $450,000 pro-rated taxexclusion amount)
Could Have Gone Back To Live In The Unit To Save More
In the abovescenario, you? be leaving $50,000 in tax-free capital gains on the .Ideally, you would move back into your home for another four and a half years,making it your primary residence for 10.5 out of 12.5 years.
The ineligiblegain for exclusion would then be 16% (2 ?12.5). $600,000 ?16% = $96,000.
That leaves$504,000 eligible for exclusion. You could then use the full $500,000 tax-freeallowance and owe long-term capital gains tax on only $4,000. So even moreprecise, you should go back and live in your rental for four years and ninemonths (3 more months) to get the full $500,000.
Im not a CPA,so please double check with a tax or real estate professional. But payinglong-term capital gains tax on a $150,000 gain is far better than paying taxeson a $450,000 or $600,000 gain. As you can see from the examples, the biggeryour capital gains, even with the pro-rated exclusion, the greater your abilityto take 100% of the tax-free exclusion amount.
Important note:
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?Since the Housing Assistance Tax Act of 2008 took effect, any rental period after 2008 before the property became your primary residence does count as nonqualified use and will reduce the amount of gain you can exclude under ?21. Specifically, for sales after January 1, 2009, any rental period before the property became your primary residence counts as nonqualified use and reduces the portion of gain you can exclude under ?21, as shown in the IRS ?inley?example in Publication 523.
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Downsides and Considerations To Moving Back Into The Rental
Of course,there are tradeoffs to saving money on capital gains tax.
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?Ill have to live in the rental again, which is not ideal since it is smaller than my current residence with only one en suite bathroom
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?The property won? generate rental income during those two years.
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?If the market weakens, I might give up gains or deal with less favorable selling conditions.
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?Depreciation recapture never goes away, it will always be taxed.
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?Id have to rent out my existing house, keep it empty, or sell it, which would the same problem. You cant have two primary residences according to the IRS.
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?Every time there is a property sale, there is economic waste in terms of fees, taxes, and commissions
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As you cansee, moving back into a rental to try and save on capital gains taxes isntalways a straightforward decision. But even with these downsides, the $500,000exclusion can more than make up for the short-term discomfort.
Strategy Summary Using The Tax-Free Home Sale ExclusionRule
Here? the bigpicture:
Action
Timing
Tax Benefit
Sold property A in Feb 2025
Met 2 of 5 rule
$500K gain excluded
Move into property B in Sept 2025
Start clock
Living requirement s
Become eligible again in Feb 2027
2 years since last exclusion
Can exclude again
Sell property B in Sept 2027
Full 2 years of primary residence met
Exclude another $500K gain after calculating the proratedcapital gains amount
Byleapfrogging primary residences and planning around the two-year exclusionrule, it? possible to exclude millions in gains over your lifetime.
Minimize Capital Gains Taxes Where You Can
The $500,000tax free home sale exclusion is one of the most powerful tools in the tax codefor building and preserving wealth. No other asset class offers this kind ofbenefit except for Qualified Small Business Stock, which comes with its ownchallenges. But like most good things, the exclusion requires patience,planning, and sometimes a little sacrifice.
If you have arental with significant appreciation and flexibility in your living situation,it could be worth the effort to move back in for two years to reset the clockon the exclusion.
After all,saving $100,000 to $169,000 in taxes every two years is like earning an extra$50,000 to $84,500 a year completely tax free. Earning $500,000 in tax-freereal estate gains is also like earning ~$750,000 in the stock market andpaying no taxes. Not a bad strategy for those who like to optimize theirfinances.
Even Easier For Non-Rental Property Owners
Alternatively,if you are climbing the property ladder toward nicer homes, you can keep using the $250,000or $500,000 capital gains exclusion with each sale. Sell four homes in yourlifetime and you and your spouse could legally avoid taxes on up to two milliondollars in capital gains. That equates to about $500,000 in tax savings.There? no need to prorate the tax-free exclusion amount either since you didnot rent out your homes.
Then when youfinally find your forever home, your heirs benefit from a stepped up cost basis when you pass so they may avoid capital gains taxesas well. Pretty awesome tax benefits if you ask me.
Homeownershipremains one of the most accessible ways for most people to build lastingwealth. Between forced savings through mortgage payments, inflation pushing up rents and home values, and the powerof leverage, the average homeowner is far wealthier than the average renter.Yes, renters can invest the difference and potentially make more money, butstatistically most do not consistently over time.
So if thegovernment offers generous tax breaks to encourage homeownership, we might aswell take full advantage. It is one of the few legal ways left to build wealthtax efficiently and potentially pass it on tax free.
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