Homeowners planning to sell their primary residence in 2026 should understand the Section 121 exclusion, a valuable tax provision that can significantly reduce or eliminate capital gains taxes on the sale. This federal tax benefit allows qualifying individuals to exclude up to $250,000 in capital gains from taxation, while married couples filing jointly may exclude up to $500,000.
Understanding the requirements, limitations, and proper documentation for this exclusion is essential for maximizing tax savings and avoiding unexpected liabilities at filing time.
Understanding the Section 121 Capital Gains Exclusion
The Section 121 exclusion represents one of the most significant tax benefits available to American homeowners. Unlike other investment gains, which are typically subject to capital gains taxes, profits from selling a primary residence can be partially or fully excluded from federal income tax when specific criteria are met.
This exclusion exists because Congress recognized that most homeowners reinvest their home sale proceeds into their next residence rather than treating the transaction as an investment gain. The provision helps facilitate housing mobility without creating prohibitive tax burdens.
Qualifying Requirements for the Exclusion
To claim the capital gains exclusion when selling a home, taxpayers must satisfy two fundamental tests:
The Ownership Test
Homeowners must have owned the property for at least two years out of the five-year period immediately preceding the sale date. These two years do not need to be consecutive. For example, a homeowner who owned a property from January 2021 through December 2022, sold it, then repurchased it in 2024, could potentially count both ownership periods toward the requirement.
The Residence Test
The property must have served as the taxpayer's primary residence for at least two of the five years before the sale. Primary residence is determined by examining where the taxpayer:
- Filed federal and state tax returns
- Registered to vote
- Maintained driver's license and vehicle registration
- Received mail and utility bills
- Conducted daily living activities
The exclusion does not apply to:
- Vacation homes or second residences
- Investment properties
- Rental properties (with limited exceptions)
- Properties used primarily for business purposes
Calculating Capital Gains on a Home Sale
Determining the taxable capital gain requires a straightforward calculation, though proper documentation is essential for accuracy.
Capital Gain = Sale Price − Cost Basis
The cost basis includes:
- Original purchase price of the home
- Closing costs paid at purchase (title insurance, attorney fees, recording fees)
- Capital improvements made during ownership
- Selling expenses (real estate commissions, transfer taxes, staging costs)
Example Calculation
Consider a homeowner who purchased a property for $300,000 in 2020, made $50,000 in capital improvements (new roof, kitchen renovation, HVAC system), and sells the home in 2026 for $550,000 with $35,000 in selling expenses.
| Item | Amount |
|---|---|
| Sale Price | $550,000 |
| Original Purchase Price | ($300,000) |
| Capital Improvements | ($50,000) |
| Selling Expenses | ($35,000) |
| Total Capital Gain | $165,000 |
For a single filer meeting all requirements, the entire $165,000 gain would be excluded from federal income tax. For gains exceeding the exclusion limit, only the amount above $250,000 (single) or $500,000 (married filing jointly) becomes taxable.
Frequency Limitations
Taxpayers should note that the Section 121 exclusion can only be claimed once every two years. Individuals who have used this exclusion within the previous 24 months are ineligible to claim it again, regardless of whether they meet the ownership and residence tests.
This limitation prevents taxpayers from repeatedly buying, improving, and selling homes to generate tax-free profits in rapid succession.
When Gains Exceed the Exclusion Limit
Any capital gain exceeding the applicable exclusion amount becomes subject to capital gains tax. The rate depends on the taxpayer's total income and filing status:
Long-Term Capital Gains Rates (Assets Held Over One Year)
| Filing Status | 0% Rate | 15% Rate | 20% Rate |
|---|---|---|---|
| Single | Up to $47,025 | $47,026 – $518,900 | Over $518,900 |
| Married Filing Jointly | Up to $94,050 | $94,051 – $583,750 | Over $583,750 |
Note: Income thresholds are subject to annual adjustments. Taxpayers should verify current thresholds for the 2026 tax year.
Additionally, high-income taxpayers may owe the 3.8% Net Investment Income Tax on capital gains if their modified adjusted gross income exceeds certain thresholds.
Special Circumstances and Partial Exclusions
Certain situations may qualify homeowners for a partial exclusion even when the standard two-year requirements are not fully met:
Qualifying Exceptions
- Employment relocation requiring a move of 50+ miles
- Health-related moves due to illness, injury, or medical care
- Unforeseen circumstances such as divorce, death, multiple births, or natural disasters
In these cases, the exclusion amount is prorated based on the percentage of the two-year requirement that was satisfied before the sale.
Documentation Requirements
Maintaining comprehensive records is essential for accurately calculating capital gains and substantiating exclusion claims. Homeowners should retain:
Purchase Documentation
- Settlement statement (HUD-1 or Closing Disclosure)
- Purchase contract
- Mortgage documents
- Title insurance policy
Improvement Records
- Contractor invoices and receipts
- Building permits
- Before and after photographs
- Canceled checks or credit card statements
Sale Documentation
- Settlement statement from sale
- Real estate commission statements
- Repair and staging receipts
- Transfer tax documentation
The IRS recommends retaining these records for at least three years after filing the tax return reporting the sale, though keeping them longer provides additional protection.
State Tax Considerations
While the federal Section 121 exclusion applies nationwide, state tax treatment varies significantly. Some states, including California, conform to federal rules and allow the same exclusion. Others may have different exclusion amounts, additional requirements, or no exclusion at all.
Taxpayers should consult with a qualified tax professional to understand their specific state obligations before completing a home sale.
Married Couples and the Exclusion
Married couples filing jointly can exclude up to $500,000 in capital gains, but both spouses must meet the residence test. Only one spouse needs to meet the ownership test.
For couples who married recently or where one spouse did not live in the home for the full two-year period, each spouse may need to calculate their exclusion separately, potentially limiting the total benefit.
Planning Considerations for 2026 Home Sales
Homeowners contemplating a sale should consider several strategic factors:
- Timing the sale to ensure full compliance with the two-year ownership and residence requirements
- Documenting all capital improvements before listing the property
- Calculating estimated gains to determine potential tax liability
- Reviewing state tax implications for the specific jurisdiction
- Consulting with tax professionals before finalizing the transaction
Professional Guidance Is Recommended
Given the complexity of capital gains calculations and the significant financial implications of home sales, taxpayers should seek professional tax guidance before completing a transaction. A qualified tax preparer can help ensure all requirements are met, all allowable deductions are claimed, and no unexpected tax liabilities arise.
For personalized assistance with capital gains calculations, home sale tax planning, or any other tax preparation needs, TIG Tax Services provides expert guidance tailored to individual circumstances. Contact our team to schedule a consultation and ensure proper tax treatment of your 2026 home sale.