Capital Gains Tax on a Home Sale: The $250,000 Exclusion

Two beliefs about selling a house are widespread and both are wrong. The first is that you owe tax on the sale price. The second is that you can avoid the tax by buying another house — a rollover rule that was repealed in 1997 and still gets repeated at every open house in America.

What replaced it is better. Most people who sell a home they've lived in owe nothing at all, and the ones who do owe something usually owe it because they threw away twelve years of receipts.

The exclusion

Section 121 lets you exclude "up to $250,000 of that gain from your income, or up to $500,000 of that gain if you file a joint return." Not the sale price — the gain. And you don't have to reinvest a dollar of it. Sell, take the money, buy a boat.

Two tests, both measured against the five years before the sale:

• Ownership — you owned the home for at least 24 months out of the last 5 years.
• Use — you lived in it as your main home for at least 24 months of the last 5 years.

The 24 months don't have to be consecutive. Two separate twelve-month stretches inside the five-year window count the same as two continuous years, which matters for people who moved out, rented the place, and moved back.

There's also a look-back rule: you're not eligible "if you excluded the gain from the sale of another home during the two-year period prior to the sale." One exclusion every two years. Married couples have an extra layer of rules for the $500,000 version, and Publication 523 spells those out.

Gain is not profit, and basis is where the money is

Gain is what you sold it for, minus selling costs, minus your adjusted basis. Adjusted basis is what you paid, plus certain purchase costs, plus every capital improvement you ever made.

That last item is the one people lose. Here's a house bought in 2013 and sold this year:

• Purchase price: $240,000
• Capitalized closing costs at purchase: $6,000
• Improvements over twelve years — roof $14,000, kitchen $32,000, HVAC $9,000, deck $8,000: $63,000
• Adjusted basis: $240,000 + $6,000 + $63,000 = $309,000
• Sale price $610,000 minus $40,000 of commission and transfer taxes = $570,000 realized
• Gain: $570,000 − $309,000 = $261,000

A married couple filing jointly excludes all $261,000 and owes nothing. A single filer excludes $250,000 and has $11,000 of taxable long-term gain.

Now delete the improvement records — the folder got tossed in a move, the contractor is gone, there's no proof. Basis falls to $246,000, gain rises to $324,000, and the single filer's taxable gain goes from $11,000 to $74,000. At a 15% long-term rate that's about $9,450 of tax created purely by lost paperwork.

What counts as an improvement

The IRS line is that improvements "add to the value of your home, prolong its useful life, or adapt it to new uses," and they increase basis. Repairs are "necessary to keep your home in good condition but don't add to its value or prolong its life" — painting a room, patching a leak — and they don't.

The exception that helps: repairs done as part of an extensive remodel count as part of the improvement. Repainting a bathroom is a repair. Repainting it during a gut renovation of that bathroom goes into basis with everything else.

Things people forget to capitalize: a new roof, replacement windows, a furnace or air conditioner, a water heater, a driveway, landscaping that's part of a larger project, a finished basement, an added bathroom, permanent fixtures. Keep the invoice, the permit and the cancelled check. A folder — physical or a photo in a folder on your phone — is the entire system.

If you don't meet the two-year tests

You may still get part of the exclusion. Publication 523 allows a reduced exclusion when the main reason for the sale was one of these:

• A work-related move — you took or were transferred to a new job "in a work location at least 50 miles farther from the home" than your old job was.
• Health — moving to obtain, provide or facilitate diagnosis, cure, mitigation or treatment of disease, illness or injury, for you or a family member.
• Unforeseeable events — the home was destroyed, a casualty loss, a death, a divorce or legal separation, multiple births from one pregnancy, or becoming unable to pay basic living expenses.

The reduced exclusion is a fraction of the exclusion amount, not of the gain — which is the part people get backwards, always to their own disadvantage. Take the shortest of three periods (time you lived there in the prior five years, time you owned it, and time since you last used the exclusion), divide by 730 days, and multiply by $250,000.

So someone who lived in a house 14 months before a job moved her 400 miles away gets 14 ÷ 24 × $250,000 = $145,833 of exclusion. If her gain was $60,000, all of it is excluded. She doesn't lose the benefit for missing the two-year mark by ten months — she loses a ceiling she was never going to hit.

The reporting rule that trips people

If you receive Form 1099-S at closing, "you must report the sale of the home even if the gain from the sale is excludable." The title company sent a copy to the IRS. Leave the sale off your return and the matching program generates a CP2000 proposing tax on the entire gross proceeds with no basis at all — which, on a $610,000 sale, is a genuinely alarming letter about a transaction on which you owed nothing.

You can often decline the 1099-S at closing by certifying the sale qualifies for exclusion. If you don't, report it on Schedule D and Form 8949 and claim the exclusion there. Ten minutes now, versus a year of correspondence later.

Depreciation is the exception that surprises landlords

If you ever rented the home out or claimed a home office deduction, you likely claimed depreciation, and that portion does not get excluded. The IRS is explicit: you can't exclude the gain equal to depreciation "allowed or allowable after May 6, 1997." That's unrecaptured section 1250 gain, it's reported on Form 4797, and it's taxed at a maximum rate of 25% — higher than the long-term capital gains rate most sellers face.

"Allowable" is doing quiet work in that sentence. It means depreciation you could have claimed counts against you whether or not you actually claimed it. A landlord who never took depreciation still owes on it at sale.

The rates, and a warning about the year

For taxable years beginning in 2025, IRS Topic 409 puts the 0% long-term capital gains rate at taxable income up to $48,350 for single filers and married filing separately, $96,700 for joint filers and surviving spouses, and $64,750 for heads of household. The 15% rate runs from there up to $533,400 single, $600,050 joint, $566,700 head of household, and $300,000 married filing separately, with 20% above.

Check Topic 409 for the year you're actually selling in. Those thresholds move every year, and at the time of writing the IRS's own topic page was still publishing the 2025 figures while its 2026 inflation-adjustment release didn't cover capital gains at all. Don't let anyone — including this page — hand you a bracket for a year they haven't looked up.

One consolation absent from this whole area: a loss on a personal residence is not deductible. The exclusion runs one way.

What to do, in order

1. Start a basis folder today, whether or not you're selling. Purchase closing statement, every improvement invoice, every permit.
2. Before listing, add it up. Purchase price plus capitalized closing costs plus improvements. That's your basis.
3. Estimate the gain against the $250,000 or $500,000 exclusion. If you're comfortably under, the tax question is settled.
4. If you're over, or you fail a test, find out whether a partial exclusion applies before you assume the worst.
5. If the property was ever rented or you took a home office deduction, get the depreciation figure out of those old returns before closing.
6. Check your state separately. States handle capital gains differently — Washington, for instance, runs a 7% capital gains tax that explicitly exempts real estate.

The most expensive mistake in this article costs about $9,450 and is entirely preventable with a folder. Go make the folder. (General information, not tax advice.)