Understanding the Home Sale Gain Exclusion (IRC Section 121)

How to Make the Most of One of the IRS’s Most Generous Tax Breaks — and Avoid a Costly Misunderstanding

For many homeowners, selling a house comes with mixed emotions — pride in what’s been built, and sometimes, a shock at how the taxes work. One of the most misunderstood sections of the tax code is IRC Section 121, which governs how much gain you can exclude from income when selling your primary residence.

Let’s break it down.

The Basics: What the IRS Allows You to Exclude

If you sell your primary home, the IRS allows you to exclude up to $250,000 of gain if you’re single, or up to $500,000 if you’re married filing jointly — meaning you pay no capital gains tax on that portion of your profit.

To qualify, you must meet two key tests:

• Ownership test: You must have owned the home for at least 2 of the last 5 years before the sale.

• Use test: You must have lived in the home as your primary residence for at least 2 of the last 5 years before the sale.

  
  

If you’re married filing jointly, only one spouse needs to meet the ownership test, but both spouses must meet the use test.

This exclusion can be used once every two years (730 days) not once in a lifetime, as some believe.

Common Misconception: “I Can Deduct My Loss If I Sell at a Loss”

This is another misunderstanding homeowners have. Unfortunately, if you sell your personal residence for less than you paid, you cannot deduct the loss — no matter how significant it is. The IRS treats your primary home as a personal-use asset, not an investment asset.

That means while gains may be partially or fully excluded, losses are not deductible.

Example: You bought your home for $600,000 and sold it for $500,000. Even though you “lost” $100,000, that loss cannot be deducted on your tax return. It’s considered a personal expense, just like a vacation or a car purchase.

Example: How the Exclusion Works

Suppose you and your spouse bought your home for $400,000, and you sell it ten years later for $950,000. That’s a $550,000 gain. Under Section 121, you can exclude $500,000 of that gain if you meet the ownership and use tests.The remaining $50,000 would be subject to capital gains tax.

If you’re single in the same scenario, you could exclude $250,000, and the other $300,000 would be subject to capital gains taxes.

What If You Don’t Meet the Full Requirements?

Another common misconception I see is if someone doesn’t meet the full requirements for the exclusion, they believe the entire exclusion is unavailable. I have seen this prompt people to stay in their home longer than necessary, or even turn down job offers to avoid having to pay capital gains taxes on an appreciated property. However, under certain exceptions, one could still potentially qualify for a partial exclusion. 

So, even if you haven’t met both the ownership and use tests — or you’ve sold your home more than once within two years — you may still qualify for a partial exclusion if your sale was due to specific unforeseen circumstances. If your expected gain is less than the partial exclusion you qualify for, then you will have no capital gains tax exposure.

The IRS recognizes several exceptions, including:

• A job relocation or change in employment that makes living there impractical

• An inability to pay living expenses after an employment change

• Health issues requiring a move

• Divorce or legal separation

• Birth of twins or other multiples

• Damage to your home from disaster

• Condemnation or seizure of property

• Other unforeseen events

  
  

These situations allow for a reduced exclusion, proportionate to the time you owned and lived in the home.

Example: You owned and lived in a home for one year before needing to move for a new job across the country. Normally, you wouldn’t qualify for the full exclusion since you didn’t meet the two-year rule. However, you may qualify for half of the exclusion — up to $125,000 (single) or $250,000 (married filing jointly). So, if the expected capital gain on the property is going to be less than $125,000 (single) or $250,000 (MFJ), then you would still be eligible to exclude the entire gain realized from the sale of your property.

Key Takeaway

The home sale exclusion under IRC Section 121 is one of the most generous benefits in the tax code, but it’s also one of the most misunderstood.

Remember:

• You can exclude $250K (single) or $500K (married filing jointly) in gains.

• You must meet both the ownership and use tests.

• You can reuse the exclusion every two years, not just once in your lifetime.

• You cannot deduct a loss on the sale of your personal residence.

• Partial exclusions may apply for legitimate unforeseen circumstances.

Why This Matters

For many families, the sale of a home is one of the largest financial events of their lives. Understanding how the exclusion works as well as its limits can prevent unpleasant surprises come tax time and help you plan more strategically for your next move.