When it comes to managing real estate wealth, tax efficiency matters. Most investment property owners are familiar with the 1031 Exchange as a way to defer taxes on commercial or rental properties. But if you’ve ever converted a rental into a primary residence — or vice versa — it’s worth understanding another key tax provision: Section 121 of the Internal Revenue Code, often called the Home Sale Exclusion.
At Realized®, we help property owners build long-term strategies that align with their income goals, estate plans, and tax considerations. Let’s look at how Section 121 works — and when it may apply to you.
What Is the Section 121 Exclusion?
Section 121 allows eligible taxpayers to exclude up to $250,000 of capital gains from the sale of their primary residence — or $500,000 if married filing jointly — from federal taxes.
This exclusion can significantly reduce or eliminate the taxable gain on a home sale as long as specific criteria are met.
Who Qualifies for the Exclusion?
To qualify for the Section 121 exclusion, you must meet the following tests:
1. Ownership Test
You must have owned the home for at least two out of the last five years before the sale.
2. Use Test
You must have used the property as your primary residence for at least two of the last five years.
3. One Sale Every Two Years
You can only claim the exclusion once every two years, regardless of how many homes you’ve sold.
If both spouses meet the use test and at least one meets the ownership test, the full $500,000 exclusion is typically available.
What If the Property Was a Rental?
This is where things get interesting for investment property owners. If you’ve converted a rental property into a primary residence, you may still be eligible for a partial Section 121 exclusion — but you’ll face additional limitations.
Since 2009, the IRS has required a pro-rata exclusion based on how the property was used. Any gain attributed to non-qualified use (time the property was a rental or vacation home after 2008) cannot be excluded under Section 121.
That portion of the gain and any depreciation recapture from the rental period is subject to tax, even if the rest of the gain qualifies for exclusion.
Can You Combine Section 121 with a 1031 Exchange?
Yes, but it’s complex. Suppose a property was originally an investment property and later used as a primary residence. In that case, you may be able to combine a 1031 Exchange with the Section 121 exclusion — though you’ll need to plan carefully. For example, you might:
- Use a 1031 Exchange when selling an investment property.
- Later, move into the replacement property and establish it as your primary residence.
- Eventually, the home will be sold, and Section 121 exclusion will be applied to part of the gain.
Timing and documentation are critical, and Realized® can help coordinate with your tax advisor to ensure compliance.
The Bottom Line
Section 121 provides a federal capital gains exclusion that may benefit homeowners meeting specific ownership and use criteria. In certain cases, this exclusion can be considered alongside other strategies—such as a §1031 exchange—to support long-term tax and real estate planning objectives.
Considering a property sale that may qualify for Section 121?
Realized® can help you explore available options in collaboration with your legal and tax advisors to align with your broader investment goals.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
