Selling Your Home? How to Exclude Up to $500,000 in Capital Gains Tax

By Holly M. Knott, CFP®
Vice President and Senior Wealth Planning Officer

 

With soaring home prices today, you can walk away with a huge profit from the sale of your home—but you can also get hit with huge taxes if you don’t know how to avoid them. The IRS offers a significant tax break under the Section 121 Exclusion, allowing you to exclude up to $500,000 in capital gains taxes on your home sale profit, if you qualify.   

Understanding the Section 121 Exclusion

When you sell a home, the profit (capital gain) is calculated by subtracting your adjusted cost basis (original purchase price plus qualifying improvements and selling expenses) from the sale price. Typically, that profit would be subject to capital gains tax. However, if you meet the eligibility requirements, you can exclude up to $250,000 as a single filer or up to $500,000 as a married couple filing jointly.

Do you qualify?  

To claim the Section 121 exclusion, you must meet the following requirements:

1. Ownership Test: You must have owned the home for at least two years in the five-year period before selling it.
2. Use Test: You must have lived in the home as your primary residence for at least two of the past five years before the sale. The two-year periods do not have to be consecutive, but they must add up to at least 24 months within the five-year window.  

The IRS provides special provisions for active-duty military personnel who have been stationed away from their primary residence, allowing them to suspend the five-year residency requirement for up to 10 years.  

Exceptions

In some cases, you may still qualify for a partial exclusion if you don’t meet the full two-year requirement. The IRS provides exceptions for special circumstances, such as:

• Health reasons: If you had to move due to a medical condition that required relocation.
• Unforeseen circumstances: Situations like job loss, divorce, or other events that forced you to move.
• Job relocation: If your new job is at least 50 miles farther from your home than your previous job.

Second homes, rental properties, and commercial properties 

The Section 121 exemption does not apply to vacation homes or rental properties unless you meet the 2-out-of-5-year rule. If you convert a rental into a primary residence, only the portion of ownership as a primary residence qualifies for the exemption.

The exemption also does not apply to commercial properties. However, a 1031 exchange can help you to defer capital gains taxes on the sale of an investment property. Learn more about 1031 exchanges. 

 How the Section 121 exclusion works (an example): 

• You bought your home ten years ago for $300,000.
• Over the years, you made $50,000 in home improvements.
• You sell your home for $700,000, and your selling expenses (closing costs, realtor fees, etc.) total $25,000.

Your adjusted cost basis is $300,000 (purchase price) + $50,000 (improvements) + $25,000 (selling expenses) = $375,000.

Your capital gain is $700,000 (sale price) - $375,000 (adjusted cost basis) = $325,000.

If you’re single, you can exclude up to $250,000, meaning you will be taxed on $75,000 ($325,000 - $250,000) in capital gains. If you’re married filing jointly, you can exclude up to $500,000, which means you have $0 tax liability. 

Washington Trust Wealth Management Can Help

The Section 121 Exclusion is a powerful tax-saving tool that can help you keep more of your money when selling your home. However, like much of the U.S. Tax Code, the provision is complex and rife with exceptions, partial exemptions, and additional rules, including those in IRS Publication 523, Selling Your Home. To maximize your tax benefits and ensure a smooth home sale, your Washington Trust wealth advisors, in collaboration with tax professionals, can help you navigate the process and maximize your savings.