Section 121 Exclusion

What is the section 121 exclusion?

The Section 121 exclusion, the home sale exclusion, lets you sell your primary residence and pay no federal tax on up to $250,000 of gain ($500,000 for married couples filing jointly). To qualify you must have owned the home and used it as your main residence for at least two of the five years before sale. The two years need not be continuous, and you can use the exclusion repeatedly, but not more than once every two years.

Investors have several ways to harness it. House hackers and live-in flippers can earn tax-free gains every two years. The two-of-five-year window means you can move out, rent the home for up to three years, and still exclude the gain when you sell. Converting a former 1031 replacement property into a residence works too, though with extra rules (five-year ownership minimum and proration for "nonqualified use").

The exclusion does not cover everything. Depreciation claimed while the home was rented (or for a home office) is recaptured at up to 25% regardless of the exclusion, and gain attributable to periods of "nonqualified use" after 2008, years the home was a rental before becoming your residence, is not excludable. Partial exclusions are available for early sales forced by job moves, health, or unforeseen circumstances.

Worked example

A couple bought a house for $300,000, lived in it for five years, and sells for $720,000. Their $420,000 gain falls under the $500,000 married exclusion, so they owe zero federal capital gains tax. Had the gain been $560,000, only the $60,000 excess would be taxable.

Frequently asked questions

Can I use the Section 121 exclusion on a rental property?

Only by making it your primary residence first, and the math gets prorated. Gain attributable to years it was a rental after 2008 ("nonqualified use") stays taxable, and all depreciation claimed during the rental years is recaptured at up to 25% no matter what. Moving into a former rental for two years can still exclude a meaningful slice of gain, it just will not wipe out the whole bill.

How does the exclusion work if I move out and rent my home before selling?

This order works in your favor. Because the test is two years of residence within the five years before sale, you can move out, rent the home for up to three years, and still claim the full exclusion (rental years after you move out do not count as nonqualified use). You will owe recapture on depreciation claimed during the rental period, but the rest of the gain up to the limit stays tax-free. Wait past three years and the exclusion disappears entirely.

Related tools and guides

• Capital Gains on Rental Property