Home Sale Exclusion (Section 121)

Your gain on a home sale is the amount realized, meaning the sale price minus selling costs such as agent commissions, less your adjusted cost basis: what you paid, plus certain closing costs and the improvements still part of the home. Section 121 removes up to $250,000 of that gain from your gross income, or $500,000 on a joint return. Gain above the limit is taxed as a long-term capital gain if you owned the home for more than a year.

Excluded gain isn’t income at all. It doesn’t raise your adjusted gross income and isn’t subject to the 3.8% net investment income tax. There is no lifetime cap: you can use it again on each later home that passes the tests.

The limits were set in 1997 and have never been indexed for inflation. For 2026 they are still $250,000 and $500,000, so a home bought decades ago in an expensive market can outgrow them.

To claim the full exclusion you must pass three tests, all measured back from the date of sale. Ownership: you owned the home for at least 24 months of the last five years. Use: you lived in it as your main home for at least 24 months, or 730 days, of those same five years. Look-back: you didn’t exclude gain on another home sale in the two years before this one.

The 24 months don’t have to be continuous, and the ownership and use periods don’t have to overlap, as long as both fall within the five-year window. Vacations and other short absences count as time lived there. If you become unable to care for yourself after living in the home at least 12 months, time in a licensed care facility counts toward the use test. Members of the uniformed services, the Foreign Service, the intelligence community and the Peace Corps on qualified extended duty can suspend the five-year window for up to 10 years.

Couples who are married filing jointly get $500,000 when either spouse meets the ownership test and both meet the use and look-back tests. A widow or widower who hasn’t remarried keeps the $500,000 limit for a sale within two years of the spouse’s death, easing the widow’s penalty on a home sale.

Selling before you meet the two-year tests doesn’t always forfeit the break. If the main reason is a change in workplace, health, or an unforeseeable event, you can claim a reduced exclusion. A work move qualifies when the new job is at least 50 miles farther from the home than the old one. Health moves include moving to get or provide treatment or care for your own or a family member’s illness or injury, or on a doctor’s advice. Unforeseeable events include the home being destroyed or condemned, a death, a divorce or legal separation, multiple births, or a change in employment that leaves you unable to pay basic living expenses.

The reduced limit is $250,000 times the shortest of three periods divided by 24 months: your time living in the home during the five years, your time owning it, and the time since you last used the exclusion. On a joint return, each spouse’s share is figured the same way and added. A single owner who lived in the home 12 months before a qualifying job transfer can exclude up to $125,000. Because the limit is prorated rather than the gain, that often still shelters all of a modest gain.

Renting out or working from a home changes the math in three ways. First, depreciation you claimed, or could have claimed, after May 6, 1997, can’t be excluded. That slice of the gain is taxed as unrecaptured Section 1250 gain at up to 25%, which is how rental property depreciation follows you into a home sale.

Second, gain allocated to nonqualified use is taxable. Nonqualified use means periods after 2008 when neither you nor your spouse lived in the home as a main residence, such as years it was a rental or second home before you moved in. The taxable share is those days divided by your total days of ownership. Time after you move out doesn’t count, so renting out a former home for up to three years before selling can keep the full exclusion, apart from the depreciation.

Third, a separate part of the property used for business or rent, like the second unit of a duplex you live in through house hacking, isn’t covered unless you also lived in that part for two of the five years. A home office or rented room inside your living space needs no split. And a home you received in a 1031 exchange must be held five years before any gain on it can be excluded.

Downsizing in retirement can free home equity largely tax-free, but gain above the limit lands in one year on top of your other income. It can push you into a higher capital gains bracket, trigger the net investment income tax, and raise Medicare IRMAA premiums two years later, while the excluded part does none of these things. Selling in a lower-income year, such as after paychecks stop, can shrink those side effects.

Holding the home until death is the main alternative. Heirs receive a step-up in basis to market value, which can erase gain the exclusion would never have covered. That trade-off leads some owners with gains far above the limit to stay put and borrow against the home instead of selling.

Keep closing statements and improvement receipts for as long as you own the home, and for three years after the due date of the return for the year you sell. Every documented improvement lowers the gain that might exceed the limit.