The $250,000/$500,000 Capital Gains Tax Exclusion for Homeowners

If you're a homeowner, the capital gains tax exclusion for your home is one tax law you need to understand thoroughly. The home sale tax exclusion allows individuals who sell their principal home to exclude from their taxable income up to $250,000 of the gain from the sale, or up to $500,000 if the sellers are a married couple who file a joint return.

Is There a Way to Avoid Capital Gains Tax on the Selling of a House?

You might owe capital gains tax if you sell a home if the property's value has appreciated. However, if you sell your principal home, you may exclude from your taxable income up to $250,000 of the gain from the sale (up to $500,000 if you're married and file a joint return.)

What Are the Two Rules of the Exclusion on Capital Gains for Homeowners?

Here's the most important thing you need to know: To qualify for the $250,000/$500,000 home sale exclusion, you must (1) own and occupy the home as your principal residence (2) for at least two of the five years before you sell it. Your home can be a house, apartment, condominium, stock-cooperative, or mobile home fixed to land.

And in some limited circumstances, you might still qualify for a partial exclusion even if you don't meet all the requirements.

The Two-Year Ownership Rule

To qualify for the home sale exclusion, you don't have to be living in the house at the time you sell it. Your two years of ownership and use can be anytime during the five years before the date of the sale. So, you can move out of the house for up to three years and still qualify for the exclusion. (I.R.C. § 121(a)).

This rule has a very practical application: It means you may rent out your home for up to three years prior to the sale and still qualify for the exclusion. Be sure to keep track of this time period and sell the house before it runs out.

Example. Casey buys a three-bedroom house on July 1, 2020, and lives in it for two full years. She then moves to another state to take a new job. Rather than sell the house, she decides to rent it out. If she sells the house by July 1, 2025, she'll qualify for the $250,000 home sale exclusion because she owned and used the house as her principal home for two years during the five-year period before the sale. If she waits even one more day to sell, she won't get an exclusion.

The Exclusion Has an Important Limit

The $250,000/$500,000 exclusion has an important limit: It doesn't apply to any depreciation deductions taken on the property after May 6, 1997. (So, this means the portion of a gain from the sale of property attributable to depreciation after May 6, 1997, isn't eligible for the exclusion.) You must reduce your applicable exclusion by the total amount of depreciation you were entitled to take during these years—that is, you must include the amount as ordinary income on your tax return.

Also, starting in 2009, tax law limits the $250,000/$500,000 exclusion for taxpayers who initially use their home as a rental, as a vacation home, or for any other use than as a principal residence (a "nonqualifying use" in IRS-speak). The amount of gain eligible for the applicable exclusion is reduced pro rata based on how many years after 2008 the home was used other than as the taxpayer's principal residence. The effect is to reduce the exclusion for landlords who convert a rental home into their personal residence.

Example. Tommy, a single taxpayer, buys a condo on March 1, 2019, for $500,000 and rents it out for the next two years. During this time, he takes $10,000 in depreciation deductions. He evicts his tenants and moves into the home on March 1, 2021, making it his personal residence. Tommy sells the condo for $650,000 on March 1, 2024. Tommy owned the condo for five years and had a $150,000 gain from the sale. However, because he used the condo as a rental for two years before he converted it into his residence, 40% of his total use of the property during the five years he owned was a nonqualifying use. His $250,000 tax exclusion must be reduced by 40%, or $100,000. So, he qualifies for a $150,000 tax exclusion. But his exclusion of gain from the sale is limited to $140,000 because he must recapture his $10,000 in depreciation deductions.

This reduction in the $250,000/$500,000 exclusion can only occur if the home was used as a rental or other nonqualifying use before it became the taxpayer's principal residence. Rental or other uses of the home after it was used as the principal residence don't constitute a nonqualified use and thus don't reduce the exclusion. This is why Casey's rental of her condo in the first example above, after she lived in it, doesn't reduce her $250,000 exclusion.

This rule applies only to nonqualifying uses occurring during 2009 and later. Uses before 2009 aren't counted and don't reduce the amount of gain eligible for the applicable exclusion.

To learn about tax deductions for landlords, get Nolo's Every Landlord's Tax Deduction Guide.

The Use Rule: Home Must Be Your Principal Residence

To qualify for the exclusion, you must have used the home you sell as your principal residence for at least two of the five years prior to the sale. Your principal residence is the place where you (and your spouse if you're filing jointly and claiming the $500,000 exclusion for couples) live.

You don't have to spend every minute in your home for it to be your principal residence. Short absences are permitted. For example, you can take a two-month vacation away from home and count that time as use. However, long absences aren't permitted. For example, a professor who is away from home for a whole year while on sabbatical can't count that year as use for purposes of the exclusion.

You can only have one principal residence at a time. If you live in more than one place—for example, you have two homes—the property you use the majority of the time during the year will ordinarily be your principal residence for that year.

If you have a second home or vacation home that has substantially appreciated in value since you bought it, you'll be able to use the exclusion when you sell it if you use that home as your principal home for at least two years before the sale.

How Often Can I Use the Capital Gains Tax Exclusion?

If you meet all the requirements for the exclusion, you can take the $250,000/$500,000 exclusion any number of times. But you may not use it more than once every two years.

The two-year rule is really quite generous because most people live in their home at least that long before they sell it. On average, Americans move once every seven years. By wisely using the exclusion, you can buy and sell many homes over the years and avoid any income taxes on your profits.

$500,000 Exclusion for Married Couples

There are certain additional requirements you must meet to qualify for the $500,000 exclusion. Namely, you must be able to show that all of the following are true:

• you are married and file a joint return for the year
• either you or your spouse meets the ownership test
• both you and your spouse meet the use test, and
• during the two-year period ending on the date of the sale, neither you or your spouse excluded gain from the sale of another home.

If either spouse doesn't satisfy all these requirements, the exclusion is figured separately for each spouse as if they weren't married. This means they can each qualify for up to a $250,000 exclusion. For this purpose, each spouse is treated as owning the property during the period that either spouse owned the property. For joint owners who are not married, up to $250,000 of gain is tax free for each qualifying owner.