Use duty-free home sales wisely every two years

In the spring of 2025, due to IRS Section 121 exclusion, I sold one of my own properties and successfully ruled out $500,000 in capital gains, tax-free. For those unfamiliar, this powerful rule allows homeowners to exclude up to $250,000 in capital gains in singles (if married co-filed), or as long as there is a co-application as long as they meet ownership and use tests.

It’s August 2025 and my tenant just informed me that they’ve evacuated one of my rental properties at the end of the next month.

Given that San Francisco’s real estate market is still relatively strong, I now face a choice: Do I sell my property and take advantage of the favorable price? Or do I stick with it and know that if I wait until 2027, I might rule out another $500,000 in capital gains – less than more?

Let’s explain how the exclusion method works, how often you can use it and why understanding this rule can save you six figures of taxes.

What is the exclusion in Section 121?

Under Article 121 of the IRS Code, you can exclude up to $250,000 in capital gains ($500,000 if married) from the sale of the primary residence.

1. You have owned at least the property for the past five years and
2. You have lived in at least two of the property over the past five years.

You can only use this exclusion Once every two years. If you sell another home within two years of the last exclusion proceeds, you cannot ask for the exclusion of that home again.

This rule not only applies to the home you have been living in. It can also be used for previously rented properties if you meet timing requirements.

Why This Is Important: My March 2025 Sales

In March 2025, I sold a house and moved out from 2020 to the second half of 2023. I moved out for about 12 months and then prepared and sold. Since I have lived in at least two of the first five years of the sale, I am eligible for the full $500,000 exclusion.

Suppose I bought the home for $1,000,000 and sold it for $1,800,000.

• Total capital gains: $800,000
• Section 121 Excluded: $500,000
• Depreciation reclaim: $10,000 (taxed 25%)
• The remaining long-term capital gains: $300,000

$10,000 for depreciation recovery is no Excluded will be taxed up to 25%, or $2,500. The remaining $300,000 in capital gains will be taxed at a long-term capital gains tax rate (usually 15%–20%, plus state tax, which may be 3.8% of NIIT).

Assuming I did a zero reshaping, my total taxable income was $315,000, distributed between depreciation recovery and regular LTCG.

Nevertheless, I saved about $100,000+ in taxes by leveraging the exclusions.

New Opportunity: Rental property tenants send notice

Fast forward to today. A tenant from one of my other rental properties just issued a notice. They have been there since January 2020 and I have not lived on the property since. Suppose I bought the house for $700,000 in 2012 and it is now worth $1.5 million.

If I sell now, my capital gains look like this:

• Sales price: $1,500,000
• Original cost basis: $700,000
• Improvements over the years: $50,000
• Adjust cost basis: $750,000
• Rent period (5 years) depreciation: $100,000
• The basis for adjustment after depreciation: $650,000 ($750,000 cost basis minus depreciation)
• Capital gains: $1,500,000 – $650,000 = $850,000
• Depreciation reclaim (taxed 25%): $100,000 = $25,000
• Sales Commission and Transfer Tax: $80,000
• Remaining income: $670,000 (taxed at long-term yield)

Since two of the past five years have not yet lived in the property, I cannot exclude Section 121, at least not yet.

But what if I left my current ideal residence to support my family and moved back to this rent for this rent, I called it home from 2014 to 2019?

Return: Five-year two-year rule

To qualify for exclusion again, I need:

• Wait for at least two years from the last time I used exclusion (February 2025 → February 2027)
• Before the sale, in the five-year window, lived in my primary residence for at least two years.

So, here is a possible game plan:

1. September 2025: Tenant leaves. I moved in and became my primary residence.
2. February 2027: Two years after I sold another home in February 2025, I’m eligible to use the exclusion again.
3. September 2027: After living there for two years, I once again met the two-year use requirement for five years.
4. Fall 2027: I sold and ruled out $500,000 in proceeds – no tax.

Let’s take a look at the revised tax mathematics.

For sale in 2027 (two years later), excluding

• Sales price: $1,550,000 (assuming modest $50,000 appreciates)
• Adjustment basis: $650,000 ($750,000 cost base minus $100,000 depreciation)
• Capital gains: $900,000
• Section 121 Excluded: $500,000
• Remaining income: $400,000
• Depreciation regain (unchanged): Taxed at $100,000, 25% = $25,000
• Sales Commission and Transfer Tax: $80,000
• The remaining capital gains are subject to LTCG tax: $220,000

This does not include $500,000 in proceeds, and according to my tax rate, there is a possibility of saving up to $125,000 in federal and state taxes. In this case, moving back to Honolulu feels like a cautious decision before moving back to move taxes.

Another option is to do a 1031 exchange to reinvest the proceeds into rental properties in Honolulu to delay all taxes. But nowadays, the idea of taking on another rent and all responsibilities is fascinating.

If I sell it early, then

What if I decide to sell before September 2027 – before another attack on my entire two-year residence period?

There is a little-known rule that allows Partial exclusion If you sell early due to unforeseeable circumstances, job changes, health issues or other eligible reasons. But it’s tricky, and the IRS strictly involves qualifying.

Partial Exclusion = (Month of owning and using month/24) × $250,000 (or $500,000)

The safest move is to wait for a full 24 months to sell.

Disadvantages and considerations of reducing rent

Of course, there are trade-offs to save money on capital gains tax.

• I had to live in the rent again, which was not ideal
• During these two years, the property will not generate rental income.
• If the market weakens, I may give up on earnings or deal with conditions where sales are less favorable.
• Depreciation reclaim will never disappear, it will always be taxed.
• I have to rent my existing home, save it or sell it, which causes the same problem. According to the IRS, you cannot own two main residences.
• Every time a property is sold, there will be financial waste

As you can see, back in rent, trying to save capital gains tax is not always a straightforward decision. But even with these drawbacks, a $500,000 exclusion can make up for short-term discomfort.

Summary of strategies for using duty-free home sales exclusion rules

Here is the overall situation:

Millions of dollars in gains can be excluded throughout your life by spanning primary residences and planning around a two-year exclusion rule.

Minimize capital gains taxes

The $500,000 free home sales exclusion is one of the most powerful tools in tax laws for building and preserving wealth. No other asset classes offer this benefit except qualified small businesses, which presents its own challenges. But like most good things, exclusion requires patience, planning, and sometimes a little sacrifice.

If you have obvious appreciation and flexibility in your life situation, it’s worth the effort to return to the clock when resetting the exclusion for two years. You might just claim that the property is your primary residence and then go around the world part of the year to make things fun.

After all, saving $100,000 to $150,000 in tax every two years is like earning an extra $50,000 to $75,000 in taxes every year. This is not a bad strategy for those who like to optimize their financial situation.

Even better for non-leased property owners

Plus, if you climb the property ladder toward a better home, you can continue to use $250,000 or $500,000 in capital gains per sale. Selling four homes in a lifetime, you and your spouse can legally avoid taxes up to $2 million. This amounts to saving about $500,000.

Then, when you finally find your eternal home, your heirs benefit from the accelerated cost when passing, so they can also avoid capital gains taxes. Are there tax benefits for home ownership?

House ownership remains one of the easiest ways most people can build lasting wealth. Through mortgage savings, inflation increases rent and home value, and the power of leverage is the average homeowner 40 times richer than the average renter. Yes, renters can invest in differences and have the potential to make more money, but statistically speaking, most people are not consistent.

So we can also make the most of the money if the government provides generous tax breaks to encourage home ownership. This is one of the few legal methods that are effective and possible to pass it through tax exemption.

Reader, someone who once returned to a rental property and lived in it for two years to take advantage of the duty-free home sales exclusion rules?

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