In Spring 2025, I bought one in all my properties and efficiently excluded $500,000 in capital good points, tax-free, due to the IRS Part 121 Exclusion. For these unfamiliar, this highly effective rule permits owners to exclude as much as $250,000 in capital good points if single, or $500,000 if married submitting collectively, from the sale of a main residence—so long as they meet the possession and use assessments.
Now it’s August 2025, and I’ve simply been notified by my tenant that they’re vacating one in all my rental properties on the finish of their lease subsequent month.
Given the San Francisco actual property market stays comparatively robust, I’m now confronted with a alternative: Do I promote the property and benefit from favorable pricing? Or do I maintain onto it, increase my semi-passive income, understanding that if I wait till 2027, I might doubtlessly exclude one other $500,000 in capital good points—tax-free?
Let’s stroll via how the exclusion works, how usually you need to use it, and why understanding this rule might prevent six figures in taxes.
What Is the Part 121 Exclusion?
Beneath Section 121 of the IRS code, you possibly can exclude as much as $250,000 in capital good points ($500,000 if married submitting collectively) from the sale of your main residence, so long as:
- You’ve owned the property for not less than two out of the final 5 years, and
- You’ve lived within the property as your main residence for not less than two out of the final 5 years.
You may solely use this exclusion as soon as each two years. In case you promote one other dwelling inside two years of your final excluded achieve, you can not declare the exclusion once more.
This rule doesn’t simply apply to houses you’ve at all times lived in. It may also be used on properties that have been beforehand rented out, in the event you meet the timing necessities.
Why This Issues: My February 2025 Sale
In February 2025, I bought a house I had lived in from 2020 to late 2023. I moved out and rented it for 12 months earlier than prepping and promoting. As a result of I had lived in it for not less than two of the previous 5 years earlier than the sale, I certified for the total $500,000 exclusion.
Let’s say I purchased the house for $1,000,000 and bought it for $1,800,000.
- Whole capital achieve: $800,000
- Part 121 exclusion: $500,000
- Depreciation recapture: $10,000 (taxed at 25%)
- Remaining long-term capital achieve: $300,000
The $10,000 of depreciation recapture is not coated by the exclusion and can be taxed at as much as 25%, or $2,500. The remaining $300,000 in capital good points can be taxed at long-term capital good points charges (usually 15%–20%, plus state taxes and presumably the three.8% NIIT). We’re speaking as much as 33.8% in capital good points tax right here in California!
Assuming I did zero reworking, my whole taxable achieve is $315,000, cut up between depreciation recapture and common LTCG. That is a painful ~$104,000 in long-term capital good points taxes.
Nonetheless, I saved $150,000+ in taxes by making the most of the exclusion. To be particular: $500,000 X 33.8% = $169,000 in taxes I must pay if there was no exclusion!
The New Alternative: Rental Property Tenant Gave Discover
Quick ahead to in the present day. A tenant in one in all my different rental properties simply gave discover. They’ve been there since January 2020, and I haven’t lived within the property since. For example I purchased the home in 2012 for $700,000 and is now price $1.5 million.
If I promote it now, my capital good points would look one thing like this:
- Sale worth: $1,500,000
- Authentic value foundation: $700,000
- Enhancements over time: $50,000
- Adjusted value foundation: $750,000
- Depreciation taken over rental interval (5 years): $100,000
- Adjusted foundation after depreciation: $650,000 ($750,000 value foundation minus depreciation)
- Capital achieve: $1,500,000 – $650,000 = $850,000
- Depreciation recapture (taxed at 25%): $100,000 = $25,000
- Promoting fee and switch taxes: $80,000
- Remaining achieve: $670,000 (taxed at long-term cap good points price)
As a result of I haven’t lived within the property for 2 of the previous 5 years, I can’t take the Part 121 exclusion—not less than not but.
However what if I depart my present ideal home for raising a family and transfer again in to this rental, which I known as dwelling from 2014-2019?
Shifting Again In: The Two-Out-of-5-12 months Rule
To qualify for the exclusion once more, I must:
- Wait not less than two years from my final use of the exclusion (February 2025 → February 2027), and
- Stay within the property as my main residence for not less than two years inside the five-year window earlier than promoting.
So, right here’s a potential sport plan:
- September 2025: Tenant leaves. I transfer again in and make it my main residence.
- February 2027: I turn into eligible to make use of the exclusion once more, two years after the February 2025 sale of one other dwelling.
- September 2027: After two full years of dwelling there, I meet the two-out-of-five-year use requirement once more.
- Fall 2027: I promote and exclude $500,000 in good points—tax-free.
Let’s take a look at the revised tax math.
Promoting in 2027 (Two Years Later) With Exclusion
- Sale worth: $1,550,000 (assuming modest $50,000 appreciation)
- Adjusted foundation: $650,000 ($750,000 value foundation minus $100,000 depreciation)
- Capital achieve: $900,000
- Part 121 Exclusion: $500,000
- Remaining achieve: $400,000
- Depreciation recapture (unchanged): $100,000 taxed at 25% = $25,000
- Promoting fee and switch taxes: $80,000
- Remaining capital good points topic to LTCG tax: $220,000
That’s $500,000 in good points excluded, doubtlessly saving as much as $169,000 in federal and state taxes relying on my tax bracket. On this case, shifting again in to unlock the tax free profit earlier than relocating to Honolulu appears like a financially prudent choice.
An alternative choice is doing a 1031 exchange to defer all taxes by reinvesting the proceeds right into a rental property in Honolulu. However the concept of taking up one other rental and all of the tasks that include it feels much less interesting as of late.
Prorated Exclusion If I Promote Early
What if I resolve to promote earlier than September 2027—earlier than hitting the total two-year residency once more?
There’s a little-known rule that permits for a partial exclusion in the event you promote early on account of an unexpected circumstance, job change, well being difficulty, or different certified purpose. Nevertheless it’s tough, and the IRS is strict about qualifying.
Partial Exclusion = (Months of possession and use / 24) × $250,000 (or $500,000)
The most secure transfer is to attend the total 24 months earlier than promoting.
Simply know that you could be additionally need to prorate the tax-free exclusion amount, relying on how lengthy you rented the property after 2009 that aren’t qualifying years.
Instance Of Professional-Score The Tax-Free Exclusion
Let’s say:
- You purchased a house in 2015.
- You lived in it as your main residence for six years (2015-2021).
- Then you definitely rented it out for two years (2021-2023).
- You bought it in 2023 with a $600,000 achieve.
- You’re married submitting collectively, so usually you’d qualify for the $500K exclusion.
However right here’s the catch:
As a result of 2 of the 8 years of possession (2019–2022) have been non-qualified use, it’s essential to prorate the exclusion:
Non-qualified use ratio = 2 years / 8 years = 25%
So, 25% of the $600,000 achieve = $150,000
This portion does NOT qualify for the exclusion.
Which means solely 80% of the achieve ($480,000) is eligible for exclusion.
So your exclusion is restricted to $480,000, not the total $500,000.
The remaining $20,000 can be taxable as long-term capital achieve. Nonetheless, not dangerous!
Necessary word:
- Non-qualified use earlier than the property was ever a main residence doesn’t rely in opposition to you (e.g., in the event you rented it first, then lived in it, you’re OK).
- This rule solely impacts time after 2009.
Downsides and Concerns To Shifting Again Into The Rental
After all, there are tradeoffs to saving cash on capital good points tax.
- I will need to stay within the rental once more, which isn’t superb since it’s smaller than my present residence with just one en suite bathroom
- The property gained’t generate rental revenue throughout these two years.
- If the market weakens, I would quit good points or take care of much less favorable promoting situations.
- Depreciation recapture by no means goes away, it can at all times be taxed.
- I might need to lease out my present home, hold it empty, or promote it, which might create the identical drawback. You may’t have two main residences in accordance with the IRS.
- Each time there’s a property sale, there may be financial waste when it comes to charges, taxes, and commissions
As you possibly can see, shifting again right into a rental to attempt to save on capital good points taxes is not at all times an easy choice. However even with these downsides, the $500,000 exclusion can greater than make up for the short-term discomfort.
Technique Abstract Utilizing The Tax-Free Residence Sale Exclusion Rule
Right here’s the large image:
| Motion | Timing | Tax Profit |
|---|---|---|
| Bought property A in Feb 2025 | Met 2 of 5 rule | $500K achieve excluded |
| Transfer into property B in Sept 2025 | Begin clock | Residing requirement begins |
| Turn out to be eligible once more in Feb 2027 | 2 years since final exclusion | Can exclude once more |
| Promote property B in Sept 2027 | Full 2 years of main residence met | Exclude one other $500K achieve |
By leapfrogging main residences and planning across the two-year exclusion rule, it’s potential to exclude thousands and thousands in good points over your lifetime.
Decrease Capital Features Taxes The place You Can
The $500,000 tax free dwelling sale exclusion is likely one of the strongest instruments within the tax code for constructing and preserving wealth. No different asset class provides this type of profit aside from Certified Small Enterprise Inventory, which comes with its personal challenges. However like most good issues, the exclusion requires endurance, planning, and generally a little bit sacrifice.
When you have a rental with vital appreciation and adaptability in your dwelling state of affairs, it might be definitely worth the effort to maneuver again in for 2 years to reset the clock on the exclusion.
In any case, saving $100,000 to $169,000 in taxes each two years is like incomes an additional $50,000 to $84,500 a 12 months fully tax free. Incomes $500,000 in tax-free actual property good points can be like incomes ~$750,000 within the inventory market and paying no taxes. Not a foul technique for many who wish to optimize their funds.
Even Simpler For Non-Rental Property House owners
Alternatively, in case you are climbing the property ladder towards nicer houses, you possibly can hold utilizing the $250,000 or $500,000 capital good points exclusion with every sale. Promote 4 houses in your lifetime and also you and your partner might legally keep away from taxes on as much as two million {dollars} in capital good points. That equates to about $500,000 in tax financial savings. There’s no must prorate the tax-free exclusion quantity both because you didn’t lease out your houses.
Then once you lastly discover your forever home, your heirs profit from a stepped up cost basis once you move so they might keep away from capital good points taxes as nicely. Fairly superior tax advantages in the event you ask me.
Homeownership stays some of the accessible methods for most individuals to construct lasting wealth. Between forced savings through mortgage payments, inflation pushing up rents and residential values, and the facility of leverage, the common house owner is much wealthier than the common renter. Sure, renters can make investments the distinction and doubtlessly earn more money, however statistically most don’t constantly over time.
So if the federal government provides beneficiant tax breaks to encourage homeownership, we would as nicely take full benefit. It is likely one of the few authorized methods left to construct wealth tax effectively and doubtlessly move it on tax free.
Readers, anyone ever transfer again to a rental property and stay in it for 2 years to benefit from the tax-free dwelling sale exclusion rule?
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