The $250,000 / $500,000 tax-free home sale profit rule is a fantastic benefit for homeowners who have lived in their homes for two out of the past five years before selling. The rule is also called the tax-free exclusion rule for real estate.
The tax-free profit exclusion rule essentially says if you are single, you can earn up to $250,000 in tax-free profits. If you are a married couple, you can earn up to $500,000 as a married couple. This tax-free exclusion rule is one of the reasons why real estate is my favorite asset class to build wealth for regular folks.
The higher the federal marginal income tax bracket you're in, the more valuable the tax-free home sale profit rule becomes. For example, imagine if taxes are increased back to 39.6% for the highest marginal federal rate. To earn $500,000 in profits after tax, you would need to have a gross profit of roughly $833,000!
The tax-free profit rule seems straight forward. However, there may be some confusion if you rent out the house before a sale. So let's clarify using an example. For background, I own multiple rental properties and have sold a property before. Real estate is my favorite asset class to build wealth and accounts for about 40% of my net worth.
Clarifying The $250,000 / $500,000 Tax-Free Home Sale Profit Rule
In the post, Buy Real Estate For Capital Appreciation, Rental Income, or Lifestyle, I responded to one reader by mentioning potentially moving back into his rental for two years in order to take advantage of the tax-free profit exclusion. I said they would have to then sell within five years after moving back to get the benefit..
Here's a great response from reader who is a tax lawyer about earning tax-free capital gains after selling a home. The tax-free exclusion rule has some nuances you should be aware of before moving back into your rental to save on taxes.
Well, I hate to be the bearer of bad news, but the rule changed a bit starting January 1, 2009. It used to be that the $250,000/$500,000 exclusion applied so long as you lived in the home for any 24 months of the 5 years preceding sale. Now there’s an exception to the exception to the rule in section 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)
The IRS chomps away at the $250k/$500k exclusion amount based on a proration of the amount of time that you’ve held the property as a rental since January 1, 2009 (note that it goes back more than 5 years now to look at the use period). The one oddball exception to that (under (b)(4)(c)(ii)) is that if you lived in the home for 2 years during the past 5, and held it out as a rental AFTER you move out, that period is still counted as qualified use.
I mapped this out once about a year ago before selling my residence-turned-rental condo. I determined that it wasn’t worth moving back in to try to recapture a proration of the exclusion amount.
Example. Let’s assume you lived in the house for 2 years starting January 1, 2009. You then converted it to a rental for 2011, 2012, 2013, 2014, 2015. Then you moved back in for 2016 and 2017 and then sold it January 1, 2018. You would have owned it for 9 years total and lived in it for 4. You would be able to exclude 4/9 of $250,000, and that’s it. Better than nothing. But if you’re reaching for the full amount of the capital gains exclusion, it’s not as generous an exclusion as it was before.
Renting Out Your Property Hurts The Tax-Free Home Sale Profit Rule
Bam! I dig the highlighting of section 121 (b)(4)(c)(ii). As you can tell from the above example, as soon as you decide to rent your property out, your tax-free profit exclusion starts getting whittled away.
One might suggest this person live in her place for longer to gain more tax-free benefits. Here's another example.
Let's say the person moves back in for 2016, 2017, 2018, 2019, 2020, 2021, 2022, 2023, 2024, 2025, 2026, 2027, 2028, 2029, 2030 and sells in 2031. They would have owned the property for 22 years, and lived in the property for 17 years. Instead of being able to exclude 4/9 of $250,000 ($111,111), they can now exclude 17/22 of $250,000 ($193,181) from the tax man.
The other solution is to never rent out your property, but sell once you want to move. The $250,000 / $500,000 in tax free profits is like making a $357,000 / $714,000 gross return on an investment for someone paying a 30% effective tax rate. That's some big bucks!
Take a look at the chart I put together for how much in gross profits you need to make with other investments at various effective tax rates.
A 1031 Exchange To Defer Capital Gains Tax
Finally, instead of selling a property for a profit, one can simply conduct a 1031 Exchange. A 1031 exchange is where you buy another property with the profits of the previous property sale so there is never a tax event.
There is no tax shelter available for stock profits, except if you reinvest in an Opportunity Zone fund or investment. But there is a powerful tax shelter for real estate owners. A 1031 Exchange is yet another reason why I prefer real estate to stocks.
The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. — 1031.org
How Many Times Can You Use The $250,000 / $500,000 Home Sale 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, since most people live in their home at least that long before they sell it.
To review, to qualify for the $250,000/$500,000 home sale exclusion, you must own and occupy the home as your principal residence for at least two years before you sell it. Your home can be a house, apartment, condominium, stock-cooperative, or mobile home fixed to land.
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. Not bad since the average homeownership tenure is now over 11 years.
As long as you have at least two years of ownership and two years of use during the five years before you sell the home, the ownership and use can occur at different times. The rule is most important for renters who purchase their rental apartments or rental homes. The time that a purchaser lives in the home as a renter counts as use of the home for purposes of the exclusion, even though the renter didn't own the home at the time.
You don't have to be living in the house at the time you sell it. Your two years of ownership and use may occur anytime during the five years before the date of the sale. This means, for example, that you can move out of the house for up to three years and still qualify for the exclusion.
Always Calculate The After-Tax Return On Your Investment
As several commenters mentioned in my Passive Income Rankings post, tax considerations is a huge part of returns.
Real estate isn't at the top of the list due to the work required. However, it's at the top of the list of money-making assets thanks to depreciation, mortgage interest deduction, the 1031 Exchange, and the $250,000 / $500,000 in tax-free profits upon sale.
The higher your effective tax rate, the more you should love investing in real estate. You should also be maxing out your 401k as well. If tax hikes happen, investing in municipal bonds will also be more attractive.. You might even want to start a lifestyle business one day by launching your own blog.
When it comes to achieving financial freedom, it's all about generating as much passive income as possible. Take a look at the short-term and long-term capital gains tax rates yourself. It's obvious that it's more tax-efficient to earn more passive investment income for a better life.
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Post-pandemic, I think the housing market will perform well for years due to the structural undersupply of housing. However, with mortgage rates rising rapidly due to inflation and the Fed's rate-hike cycle, demand for real estate should wane. This is your opportunity to look for deals and invest.
The Tax-Free Profit Exclusion Rule is a Financial Samurai original post. I've been writing about personal finance since 2009. Financial Samurai is one of the largest independently-personal finance sites with over 1 million organic visitors a month. Subscribe to my free newsletter.
Excellent information above, however, I still have a question that is not answered in the above information. Recently I’ve asked a couple of people who sold homes, in Delaware, this same question and no one knew the answer.
The question is….. What happens to the capital gains if you sell your home for more than the profit margin allowed??? I bought my home for $242,000 in 2003. The fair market pricing in my area for my home is over $500k today. What happens if I sell my home for $510,000. Do I ONLY pay the capital gains taxes on the amount OVER the allotted amount, in this case $268,000 (242k + 268k= 510k)….the last $10k is the real question. Or will the system make me pay taxes on the ENTIRE $268,000 since a portion of that is over the threshold????
PS….I still owe $90K on the mortgage and it’s always been my primary residence
Hi Kyle,
If you sell your home for more than the $250,000 exclusion (for singles) or $500,000 exclusion (for married couples filing jointly), you’ll only pay capital gains taxes on the amount that exceeds the exclusion.
Let’s break it down using your example:
1. Purchase Price (Basis): $242,000
2. Selling Price: $510,000
3. Profit (Capital Gain): $510,000 – $242,000 = $268,000
As a single filer, you qualify for a $250,000 exclusion on the profit from your primary residence. This means:
• Excludable Profit: $250,000
• Taxable Profit: $268,000 – $250,000 = $18,000
You will only pay capital gains taxes on the $18,000, not the entire $268,000.
The mortgage balance you still owe ($90,000) doesn’t affect the calculation of capital gains, as taxes are based on the profit from the sale, not the remaining debt.
Important Notes:
• To qualify for the exclusion, you must have owned and lived in the home as your primary residence for at least 2 of the last 5 years before the sale.
• If you made significant capital improvements (e.g., remodeling or adding a deck), you can add those costs to your purchase price, reducing the taxable gain further.
For example, if you spent $20,000 on home improvements, your adjusted basis would increase to $262,000 ($242,000 + $20,000), which would reduce your taxable gain to $8,000.
Regards,
Sam
I bought my cute Victorian home over 20 years ago and am now realizing a huge discriminatory taxing practice against single people. I never wanted to marry and have worked twice as hard to own my home. Now that I’m thinking of selling, I find out married people get twice as much of a break than a single person! WTH? (Is this correct or close? Sell a million dollar home and 250k is all the single person doesn’t get taxes on so at 32% they’d save 80k whereas a married couple would get a 500k tax break at 32% , so they’d save 160k in taxes!) I’ve worked soooo much harder to own my home! It jus is not fair…). The tax break should be attached to the property NOT to a persons choice or misfortune of being single, divorced, widowed etc. I’m actually really angry about this- there are lots of statistics about how many more single people own homes these days and the federal government needs to abolish this convoluted archaic punishment against a massive amount of people. They also said they were going to raise the capital gains tax break to one million (500k is too low anymore) for the primary property when sold. Who can I write and get involved in changing this discriminatory federal tax law? Thank you ,Sam. You’ve given me advice before and now that I’m almost 65 I’m ready to sell all of my rentals and primary house and find a lakeside condo with a killer view!
I bought this single-family house in California in 1989 and rented it out shortly thereafter. The house remained a rental property until mid-2022 when I moved into it. I plan to move out and sell this house in early 2024 to perform a 1031 exchange, where I intend on buying a townhouse in another state (as the exchange) and continue to rent it out. My question is: Am I required to rent out this California house for a certain period of time after I moved out in early 2024, before selling it to do the 1031 exchange? I don’t intend on taking any tax deduction following the sale since all the money will be used to buy the townhouse, which will cost more. Thank you for your guidance!
how many times can you use the 250/500 exclusion in your lifetime? ie. can you keep buying more expensive homes and take the 500k exclusion over and over?
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, since most people live in their home at least that long before they sell it.
If you setup LLC to hold the property and rent for 3 year and move back for another 3 years and sold for a net profit of $100,000, Can you enjoy the $250k exclusion benefit?
Thanks,
Rita
I bought my house four family in 1978 I have lived here ever since I want to sell it now does my husband and I get the $500,000 nontaxable when we sell
You should. But double check with your agent and accountant.
I’ve owned a rental for 16 years that I lived in for 2 years before buying another primary home 2 years ago. I also own a primary home in AZ and live in each 6 months. I’ve depreciated the rental except for the 2 years I lived there. Do I get the $250K exemption or do I get 1/8 of the exemption (2 out of 16 years), or do I get a big fat nothin? Thank you!
Spoke to my accountant about this recently. It would be 1/8 of the exemption
Helllo, I am selling my studio in a coop building in New York City. I have some questions around IRS 121 exclusion, Capital Gains Tax. I purchased a studio for $ USD 180,000 in June 2001. I resided in studio for 13 years from June 2001 to Sept. 2013.
On Sept 2013 I moved to the Philippines due to a job offer. My nephew occupied the unit from 2013 to 2017 and paid no rental. My tax filling did not reflect rental income nor any depreciation for the unit during this period. The unit was rented from July 2017 to July 2020 (3 years) and I have claimed depreciation as part of my tax filling for these years. I am now selling the unit at USD 400,000. After selling the unit, I have no plans of using the gains to purchase another property or re investing in real estate. Based on my limited experience, I believe can deduct 6% broker fee, 3% Coop Flip Tax, approximately 2% NY and State tax from the Selling Price. Is my understanding correct?
I believe that although I am a USA citizen, I am considered as a non-resident due to the length of time that I have been away and might not be eligible to use the one time tax free profit exception of USD 250,000 as a single person based on the IRS 121 exclusion clause. Is my understanding correct? I would like to know how much CAPITAL GAINS TAX that I need to pay from selling my unit.
I purchased a home in foreclosure for 155,000 I used it as a vacation home for 5 years and now have used it as a vacation rental for a year and a half. I want to do a 1031 exchange for a property equal in value of what I can sell this property for. It will probably sell for about 375,000-400,000. Can I put the house on the market now instead of waiting the extra 6 months ?
It is not my primary residence and never has been.
Hi,
I bought a property in 2012 and lived there until middle of 2018. I have been renting it out for one year. If I sell the property within 3 years after moving/renting it out, am I still eligible for the whole $250,000 (single)/$500,000 (married) capital gain exemption? Or it needs to be prorated?
You should be able to take the whole $250/500k exemption. Consult your favorite tax pro to be sure, but if you bought in 2012 and moved in right away, and you lived there for more than two years and then converted to a rental and sold within 3 years of moving out, you should be able to take the whole thing. There may be some depreciation recapture if you depreciated part of the property after turning it into a rental. But consult your tax person to be 100% sure. Or if you normally prepare and file your own returns using TurboTax or some other program, open your last year’s tax file, save as a new file, and pretend you sold your house. See what it does to your tax situation.
Here is our situation. Purchased a duplex in 1995, we resided in the back and rented the front for 24 years (claimed the income of the rental). Since then the renters moved out November 2018. and is now vacant as we fix it up. We are still living in the back. Daughter will be moving into the front unit. So I would call it our home (compound) vs an investment rental. We purchased the duplex for 300K now worth 2M. We owe a little shy of 400K. So, my question is:
If daughter plans on living there (or we keep it vacant for two years). Do we qualify for the 500K deduction. If we sell we would buy a single family home (and the 1031 does not apply). Wondering how much if any of the 1M equity we would need to pay the tax man.
Thanks
I am married and planning to purchase my Personal Residence in California under single member LLC. What about the 121 exemption if I purchase it under single member LLC?
I have the same question.
Hello. After a long drawn out process trying to sell my house I finally have a buyer. It has been just over three years since I moved out of the house and into my new one. I never rented the old house, had a couple different sales fall through over the years. Am I now out of luck completely for the capital gains exclusion as I have only lived in the house 20 months of the past 60 despite having no renters?
Thanks!
Look up the rules on prorated exclusions. See if one of the allowable reasons such as health or job move apply to you.
Thanks for the feedback Dave, I did review those and unfortunately would not qualify for any of them.
Hi. With both tax plans it looks like real estate capital gains exclusion will go from 2of 5 years to 5 of 8 years. My question is will this be retro active or implemented for properties purchased starting in 2018? I’m contemplating selling in 2018 but have lived in the house 3 years. If the plan is retroactive to propterires purchased prior to 2018 then it may keep me in my current house for 2 more years, which I hope is not the case. Thanks for your help.
Yetisaurus, or anybody subscribed to this thread. Quick question:
Do you have to live in the property for 2 of the last 5 years to get any benefits? What if you live in your house for 1 out of the last 5 years? How does the math work?
What about if you live in the house for 1.5 of the last 5 years before selling. Does the IRS include the half a year as a full year in the 2 out of last 5 year calculation?
Let’s use an example:
Purchase year: 2005
Years lived in it: 7 years
Rented it out for: 3.5 years
Total years ownership: 11.5 years
Is the math 7 / 11.5 = 60.8% X $500,000 = $304,347 in tax free profits for married couple?
or is the math
7 / 12 (b/c the IRS allows you to round up your half year of living as one full year) = 58.33% X $500,000 = $291,666?
Or, is it possible that because the person hasn’t lived in the place for a full two years, there’s an even greater reduction in the benefit, or no benefit at all?
Thanks
Hey Sam,
If you don’t meet the 2 out of 5 rule, you don’t get any cap gains exclusion at all. Sorry, man. I had the same problem with my rental condo. :-/
But what about if you lived in it for one year and 10 months. Does the IRS allow you to round up? How will the IRS know you didn’t live in the place for exactly 24 months out of the past five years?
On the tax return I think they make you report the move in and move out date. You could write whatever you want, but I think it’s under penalty of perjury and if they audit you they might require bank statements or utility bills or some other proof that you lived there for that time. Or if you had tenants in the property at any time near then, they might require documentation to show the tenants moved in after the date that you reported moving out.
Short answer: you could always lie, but it might come back to bite you.
Hi Sir, I have a question:
I brought a land in 1980($32,000) and sold the land in 2004(#300,000), use 1031 exchange to purchase a single family house for renting. Now I am thinking to sell the rental. Can I move to the house as the primary resident for two years and take the $ 500,000 couple exemption?
I have lived in my condo for 2.5 years and I have lived in it as my primary residence the entire time. I rented out my guest room to a friend for 0.5 years. I claimed this as rental income on my 2014 taxes, and deducted some expenses. I am now selling. I am single/unmarried and making less than $250,000 profit. Will capital gains and/or recapture taxes apply? There are similar questions on the internet, but mine is different because it is not a rental property, I just rented out a room within my primary residence/single family dwelling for a short period of time. I am in CA if that matters. Please help.
Clarification. I deducted expenses, but not depreciation.
Hi Chris,
First, a little bit of bad news. I think you should have taken depreciation for that portion of your house for 2014. The good news is that it’s not too late to amend your 2014 return to take that depreciation. If you don’t take the depreciation, you will still be deemed to have taken it and it will reduce your basis in the property on sale.
From the IRS:
Claiming the correct amount of depreciation. You should claim the correct amount of depreciation each tax year. If you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted.
If you deducted an incorrect amount of depreciation for property in any year, you may be able to make a correction by filing Form 1040X, Amended U.S Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in chapter 2 of Pub. 527 for more information.
Next issue: the capital gains. Read IRS publication 523. https://www.irs.gov/pub/irs-pdf/p523.pdf I pulled it up and read it for the last 25 minutes. It seems to me (in my fast reading) that you are required to figure your basis as if you took depreciation, whether or not you actually took it. (This is why you want to go back and amend 2014.) You take the sales price, minus expenses of sale, minus that depreciation. That’s your gain.
Then, on p 14 of the publication, you calculate how much of the gain is excludable. If you don’t meet both tests listed (and it seems that you don’t), you have to recapture that gain that you just had to amend your return to deduct. That recaptured gain is taxable at the recapture rate (25%) and the rest is excluded if below $250,000.
Read it for yourself and make your own determination. I gotta get to work so I can’t dig into it any deeper. Good luck!
Explain to me WHY a married couple gets twice as much deductible as a single person, (me) when I paid full price for my
home, did it alone, paid the property taxes, alone…
I think, I SHOULD get the same amount… or more.
I feel discriminated. It’s hard enough being single. Why shouldn’t I get the same benefits?
Because before people are married, they are single, and single people also pay “full price” for their homes and all the taxes along with it.
Given this string of posts has enduring value, it would be worth updating the introductory material under the caption “Here’s a great response from reader, Yetisaurus: … on 121(b)(4). (Note: it’s the second subparagraph (4) under subsection (b)–apparently the legislature mistakenly enacted two sections called (b)(4).)”
Per the notes at the bottom of https://www.law.cornell.edu/uscode/text/26/121, P.L. 113-295 fixed the duplicate (b)(4) error. The second subparagraph (4) is now subpargraph (5).
Please scroll up to see another response from me. There is a formula documented. And how years are treated changed along the way….
Please help! We sold a rental house and the profit we 1031 exchanged it to another rental house. We rented the new rental house for 8 years since 2006 up till 2014. Now we moved into the rental house as our primary house since last year of 2014 and by Sept. 2016 we will be living in this house for 2 years. are we qualify to get the 250k/500K if we sold this house since this house is a 1031 rental ? Is 2 years all we need to live there as our primary residence to qualify for the tax exemption ? Another question is .. is there a chance that we can sell it sooner maybe 18months to live there only and sell and still qualify for the capital gain tax free ?
Thanks _gloria
Gloria,
Rules have changed. I think you used to be able to get away with something like this, but not anymore. You’ll have to do a bit of research to clarify the details, but I think you can only qualify for a small share of the 250/500, like 2/(years since purchase of first rental), and I think you’ll also have to pay taxes on depreciation.
Highly insightful info.
I need to understand one technicality:
Currently, spouse and I own/live in a Single-Family house.
In about 2.5 to 3 months we move to our new bigger house (we are in contract, but only get possession in June). How do I ‘formalize’ my move-date for Tax purposes? – This would be the date my current residence ceases to be my primary residence.
Once I have that date – my deadline would be 3-years from that date, as discussed above – to reap the full $500k exclusion. Crossing the 3-year mark unintentionally could be an expensive mistake…
Thanks!
-Richie
Owning rentals through a trust is particularly safe. Naming yourself the current beneficiary and remainder beneficiary, but hiring a fiduciary to act as a trustee whom will manage all rentals, is perhaps the safest method of real estate rental investments.
Because all profits are funneled through the trust and taxed at an individual level ..instructed in the trust document… (the beneficiary) cannot ever be liable for any mishaps or lawsuits arising from the rental properties. Only the trustee can be liable as well as the trust can be at risk, but a trust per property protects other properties.
Hi Sam,
Just found your website and really excited to learn valuable investment advices from you. Im in process of buying a house(townhouse). SHould I go with 7/1 ARM (saves me about $150/month) or 30 year loan? I think at some point I will want to upgrade to regular house in the future and was thinking about selling it. But reading your post of keeping property as long as possible for appreciation, make me think maybe i should go with 30 year fixed. any suggestion?
Question: If you live in a house for a number of years, then move out and rent it for a little over 3 years, is any exclusion available to you at all? For example, suppose you sell after 4 years. Do you still get half of the 250 / 500 K exemption, since you lived in the house for 1 of the past five years?
If the answer is yes, a followup question. Suppose the capital gain were only 50K, and you lived in the place 1 of the previous 5 years (the above scenario). Since this gain is less than half of 250K would you get the entire gain tax free? Or would you only get half the gain (25K) tax free?
Unfortunately, no. You have to own and live in the house for at least 2 years of the 5 years prior to sale in order to get any portion of the exclusion. Take a look at Internal Revenue Code section 121 if you want to see the details.