In Spring 2025, I sold one of my properties and successfully excluded $500,000 in capital gains, tax-free, thanks to the IRS Section 121 Exclusion. For those unfamiliar, this powerful rule allows homeowners to exclude up to $250,000 in capital gains if single, or $500,000 if married filing jointly, from the sale of a primary residence—as long as they meet the ownership and use tests.
Now it’s August 2025, and I’ve just been notified by my tenant that they’re vacating one of my rental properties at the end of their lease next month.
Given the San Francisco real estate market remains relatively strong, I’m now faced with a choice: Do I sell the property and take advantage of favorable pricing? Or do I hold onto it, boost my semi-passive income, knowing that if I wait until 2027, I could potentially exclude another $500,000 in capital gains—tax-free?
Let’s walk through how the exclusion works, how often you can use it, and why understanding this rule could save you six figures in taxes.
What Is the Section 121 Exclusion?
Under Section 121 of the IRS code, you can exclude up to $250,000 in capital gains ($500,000 if married filing jointly) from the sale of your primary residence, as long as:
- You’ve owned the property for at least two out of the last five years, and
- You’ve lived in the property as your primary residence for at least two out of the last five years.
You can only use this exclusion once every two years. If you sell another home within two years of your last excluded gain, you cannot claim the exclusion again.
This rule doesn’t just apply to homes you’ve always lived in. It can also be used on properties that were previously rented out, if you meet the timing requirements.
Why This Matters: My February 2025 Sale
In February 2025, I sold a home I had lived in from 2020 to late 2023. I moved out and rented it for 12 months before prepping and selling. Because I had lived in it for at least two of the past five years before the sale, I qualified for the full $500,000 exclusion.
Let’s say I bought the home for $1,000,000 and sold it for $1,800,000.
- Total capital gain: $800,000
- Section 121 exclusion: $500,000
- Depreciation recapture: $10,000 (taxed at 25%)
- Remaining long-term capital gain: $300,000
The $10,000 of depreciation recapture is not covered by the exclusion and will be taxed at up to 25%, or $2,500. The remaining $300,000 in capital gains will be taxed at long-term capital gains rates (typically 15%–20%, plus state taxes and possibly the 3.8% NIIT). We’re talking up to 33.8% in capital gains tax here in California!
Assuming I did zero remodeling, my total taxable gain is $315,000, split between depreciation recapture and regular LTCG. That’s a painful ~$104,000 in long-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 no exclusion!
The New Opportunity: Rental Property Tenant Gave Notice
Fast forward to today. A tenant in one of my other rental properties just gave notice. They’ve been there since January 2020, and I haven’t lived in the property since. Let’s say I bought the house in 2012 for $700,000 and is now worth $1.5 million.
If I sell it now, my capital gains would look something like this:
- Sale price: $1,500,000
- Original cost basis: $700,000
- Improvements over the years: $50,000
- Adjusted cost basis: $750,000
- Depreciation taken over rental period (5 years): $100,000
- Adjusted basis after depreciation: $650,000 ($750,000 cost basis minus depreciation)
- Capital gain: $1,500,000 – $650,000 = $850,000
- Depreciation recapture (taxed at 25%): $100,000 = $25,000
- Selling commission and transfer taxes: $80,000
- Remaining gain: $670,000 (taxed at long-term cap gains rate)
Because I haven’t lived in the property for two of the past five years, I cannot take the Section 121 exclusion—at least not yet.
But what if I leave my current ideal home for raising a family and move back in to this rental, which I called home from 2014-2019?
Moving Back In: The Two-Out-of-Five-Year Rule
To qualify for the exclusion again, I need to:
- Wait at least two years from my last use of the exclusion (February 2025 → February 2027), and
- Live in the property as my primary residence for at least two years within the five-year window before selling.
So, here’s a possible game plan:
- September 2025: Tenant leaves. I move back in and make it my primary residence.
- February 2027: I become eligible to use the exclusion again, two years after the February 2025 sale of another home.
- September 2027: After two full years of living there, I meet the two-out-of-five-year use requirement again.
- Fall 2027: I sell and exclude $500,000 in gains—tax-free.
Let’s look at the revised tax math.
Selling in 2027 (Two Years Later) With Exclusion
- Sale price: $1,550,000 (assuming modest $50,000 appreciation)
- Adjusted basis: $650,000 ($750,000 cost basis minus $100,000 depreciation)
- Capital gain: $900,000
- Section 121 Exclusion: $500,000
- Remaining gain: $400,000
- Depreciation recapture (unchanged): $100,000 taxed at 25% = $25,000
- Selling commission and transfer taxes: $80,000
- Remaining capital gains subject to LTCG tax: $220,000
That’s $500,000 in gains excluded, potentially saving up to $169,000 in federal and state taxes depending on my tax bracket. In this case, moving back in to unlock the tax free benefit before relocating to Honolulu feels like a financially prudent decision.
Another option is doing a 1031 exchange to defer all taxes by reinvesting the proceeds into a rental property in Honolulu. But the idea of taking on another rental and all the responsibilities that come with it feels less appealing these days.
Prorated Exclusion If I Sell Early
What if I decide to sell before September 2027—before hitting the full two-year residency again?
There’s a little-known rule that allows for a partial exclusion if you sell early due to an unforeseen circumstance, job change, health issue, or other qualified reason. But it’s tricky, and the IRS is strict about qualifying.
Partial Exclusion = (Months of ownership and use / 24) × $250,000 (or $500,000)
The safest move is to wait the full 24 months before selling.
Just know that you may also have to prorate the tax-free exclusion amount, depending on how long you rented the property after 2009 that aren’t qualifying years.
Example Of Pro-Rating The Tax-Free Exclusion
Let’s say:
- You bought a home in 2015.
- You lived in it as your primary residence for 6 years (2015-2021).
- Then you rented it out for 2 years (2021-2023).
- You sold it in 2023 with a $600,000 gain.
- You’re married filing jointly, so normally you’d qualify for the $500K exclusion.
But here’s the catch:
Because 2 of the 8 years of ownership (2019–2022) were non-qualified use, you must prorate the exclusion:
Non-qualified use ratio = 2 years / 8 years = 25%
So, 25% of the $600,000 gain = $150,000
This portion does NOT qualify for the exclusion.
That means only 80% of the gain ($480,000) is eligible for exclusion.
So your exclusion is limited to $480,000, not the full $500,000.
The remaining $20,000 will be taxable as long-term capital gain. Still, not bad!
Important note:
- Non-qualified use before the property was ever a primary residence does not count against you (e.g., if you rented it first, then lived in it, you’re OK).
- This rule only affects time after 2009.
Downsides and Considerations To Moving Back Into The Rental
Of course, there are tradeoffs to saving money on capital gains tax.
- I’ll 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
- The property won’t generate rental income during those two years.
- If the market weakens, I might give up gains or deal with less favorable selling conditions.
- Depreciation recapture never goes away, it will always be taxed.
- I’d have to rent out my existing house, keep it empty, or sell it, which would create the same problem. You can’t have two primary residences according to the IRS.
- Every time there is a property sale, there is economic waste in terms of fees, taxes, and commissions
As you can see, moving back into a rental to try and save on capital gains taxes isn’t always a straightforward decision. But even with these downsides, the $500,000 exclusion can more than make up for the short-term discomfort.
Strategy Summary Using The Tax-Free Home Sale Exclusion Rule
Here’s the big picture:
| 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 begins |
| 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 |
By leapfrogging primary residences and planning around the two-year exclusion rule, it’s possible to exclude millions in gains over your lifetime.
Minimize Capital Gains Taxes Where You Can
The $500,000 tax free home sale exclusion is one of the most powerful tools in the tax code for building and preserving wealth. No other asset class offers this kind of benefit except for Qualified Small Business Stock, which comes with its own challenges. But like most good things, the exclusion requires patience, planning, and sometimes a little sacrifice.
If you have a rental 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 clock on 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-free real estate gains is also like earning ~$750,000 in the stock market and paying no taxes. Not a bad strategy for those who like to optimize their finances.
Even Easier For Non-Rental Property Owners
Alternatively, if you are climbing the property ladder toward nicer homes, you can keep using the $250,000 or $500,000 capital gains exclusion with each sale. Sell four homes in your lifetime and you and your spouse could legally avoid taxes on up to two million dollars in capital gains. That equates to about $500,000 in tax savings. There’s no need to prorate the tax-free exclusion amount either since you did not rent out your homes.
Then when you finally find your forever home, your heirs benefit from a stepped up cost basis when you pass so they may avoid capital gains taxes as well. Pretty awesome tax benefits if you ask me.
Homeownership remains one of the most accessible ways for most people to build lasting wealth. Between forced savings through mortgage payments, inflation pushing up rents and home values, and the power of leverage, the average homeowner is far wealthier than the average renter. Yes, renters can invest the difference and potentially make more money, but statistically most do not consistently over time.
So if the government offers generous tax breaks to encourage homeownership, we might as well take full advantage. It is one of the few legal ways left to build wealth tax efficiently and potentially pass it on tax free.
Readers, anybody ever move back to a rental property and live in it for two years to take advantage of the tax-free home sale exclusion rule?
Diversify Into Passive Private Real Estate
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