Selling a Home With a Large Gain: The $250,000/$500,000 Exclusion and Its Limits

The home sale exclusion has not changed since 1997. Bay Area home prices have. For many long-time owners, the excluded portion is now the smaller part of the gain.

Congress set the Section 121 exclusion at $250,000 per person nearly three decades ago and never indexed it. In most of the country that still shelters a home's full gain. In Santa Clara and San Mateo counties, where median single-family prices are around $1.92 million and $2.15 million, a family that bought in 2005 for $800,000 can easily face $1 million or more of gain, of which $500,000 is excluded and the rest is fully taxable. Understanding the rules, the exceptions, and the tax on the excess helps owners decide whether and when to sell.

The basic rules

According to IRS Topic 701, a taxpayer may exclude up to $250,000 of gain on the sale of a main home, or $500,000 for a married couple filing jointly, if the owner has both owned the home and used it as a principal residence for at least 24 months out of the five years before the sale. The two years need not be continuous. The exclusion is generally unavailable if you excluded gain on another home within the prior two years. For the $500,000 amount, either spouse can meet the ownership test but both must meet the use test.

Computing the gain

The gain is the sale price less selling costs less adjusted basis. Basis starts with the purchase price and closing costs and is increased by capital improvements. IRS Publication 523 explains that improvements which add value, such as a new roof, an addition, or upgraded systems, increase basis, while routine maintenance like painting or fixing leaks does not. Owners who have lived in a home for twenty years often have poor records of improvements, and every undocumented dollar of basis is a dollar taxed as gain, so rebuilding that history from permits and invoices is worth the effort.

Partial exclusions and special situations

Publication 523 allows a partial exclusion when a sale before the two-year mark is caused by a job relocation at least 50 miles farther away, a health reason, or an unforeseeable event such as death, divorce, job loss, or a disaster. The exclusion is prorated by the fraction of two years the owner qualifies. A surviving spouse may use the $500,000 amount if the sale occurs within two years of the other spouse's death and the requirements were met at that time.

Two rules cut the other way. Any depreciation claimed on the home after May 6, 1997, for example from a home office or a period of rental, cannot be excluded and is taxed as ordinary income up to a 25% rate. And under the nonqualified use rule, periods after 2008 when the property was not the owner's principal residence, such as years as a rental before moving in, reduce the excludable gain proportionally.

The tax on the excess

Gain above the exclusion is long-term capital gain. For 2026, the federal rate is 15% up to $545,500 of taxable income for single filers and $613,700 for joint filers, and 20% above that. The 3.8% net investment income tax applies to the taxable portion of the gain once modified AGI exceeds $200,000 or $250,000, and a large sale by itself will usually push income past those thresholds. California taxes the gain as ordinary income at rates up to 13.3%. Consider a hypothetical couple with $700,000 of gain after the $500,000 exclusion and otherwise high income: the combined federal, NIIT, and California tax could exceed $250,000.

Planning considerations

Because the sale is usually a single-year event, timing and structure matter. Selling in a year with lower other income, for instance after retirement, can reduce the federal rate on some of the gain. An installment sale can spread gain across years, at the cost of carrying a note. Converting the home to a rental and later exchanging it under Section 1031 is possible but sacrifices the exclusion if the owner moves out for too long. Holding the home until death provides a stepped-up basis to heirs, and under Proposition 19 owners who are 55 or older can transfer their property tax base to a replacement home anywhere in California up to three times, which can make downsizing more affordable than selling would otherwise be. Each approach trades tax savings for constraints on where and how you live.

This article is educational only and is not tax, legal, or investment advice. The home sale exclusion involves basis records, use history, and state rules that vary by situation, and readers should consult a qualified tax professional before selling.

Important Disclosures

Important Disclosures: Propulsion Capital Management is an investment adviser registered with the State of California Department of Financial Protection and Innovation. Registration does not imply a certain level of skill or training. This article is provided for general informational and educational purposes only and does not constitute investment, tax, legal, or accounting advice, nor an offer or solicitation to buy or sell any security or to adopt any particular investment strategy. The information is believed to be accurate as of the date of publication but is subject to change without notice; tax laws and regulations change frequently and their application depends on individual facts and circumstances. Nothing herein should be relied upon as a substitute for personalized advice from a qualified professional. Investing involves risk, including the possible loss of principal, and past performance is no guarantee of future results. Diversification does not ensure a profit or protect against loss. Any examples are hypothetical, are for illustrative purposes only, and do not reflect the experience of any client. Links to third-party websites are provided for convenience; Propulsion Capital Management does not endorse, and is not responsible for, the content of third-party sites. Propulsion Capital Management does not provide tax or legal advice; please consult your tax adviser or attorney regarding your specific situation.