Understanding Capital Gains Taxes in Real Estate Sales and Using the IRS Section 121 Exclusion (aka the Homeowners Exemption or Homeowners Exclusion) Saving $250,000 or $500,000 of Taxable Gains

• March 18, 2025
• devinlucas

Videos links here (short version and long version); scroll down for the complete article…

Short version video – get the basics in 3 minutes!

Long version video – really get into it in 32 glorious minutes!

Article (for those that still prefer to read!):

Simply put – If you have a capital gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income for single filers, or up to $500,000 of that gain if you are married and file a joint return with your spouse. 

See below discussions on the two part “test” for qualification, examples and more information.

These rules have been in place since 1997.  Prior to 1997, different rules applied that let homeowners avoid capital gains taxes by rolling their profits into another home, as long as the purchase price of the new house was equal to or greater than the home they sold.  Those are long gone and replaced by the new $250,000 / $500,000 exclusions, regardless if you buy a new home or not.  See below for some notes on potential taxes due if you rolled over prior to 1997 and are now seeking to sell that home.   

How To Qualify For The $250,000 or $500,000 Exclusions: Two Part Test 

There are TWO tests for qualification; you must pass both tests…. “the ownership test” and “the use test”…. 

– “The Ownership Test”: If you owned the home for at least 24 months (2 years) out of the last 5 years leading up to the date of sale (date of the closing), you meet the ownership requirement. For a married couple filing jointly, only one spouse has to meet the ownership requirement.

– “The Use Test” / Residency: If you owned the home and used it as your residence for at least 24 months of the previous 5 years, you meet the residence requirement.  Note: The 24 months of residence can fall anywhere within the 5-year period, and it doesn’t have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period.  However, if you used the property as a rental for that time, you still may have depreciation recapture considerations.  Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the full exclusion.

If you meet these tests, great, you can exclude $250,000 (single) or $500,000 (married filing jointly) from the gain of your sale.  

There are, of course, exceptions to the two-year rule and full exclusion requirements. For example, certain situations may allow for a partial exclusion of gain — even if you don’t meet the full two-year use or ownership tests. These include circumstances such as a job relocation, a change in health, or unforeseen events like a divorce, the death of a spouse, or the need to move due to natural disasters or destruction of the home. Certain time away due to military or government service may also extend your eligibility window. Refer to IRS Publication 523 for the full list of exceptions, eligibility rules, and limitations on exclusion amounts.

How Does the The $250,000 or $500,000 Exclusion Work in a Divorce?

Divorce can complicate how the IRS Section 121 capital gains exclusion is applied. The key question is when the home is sold and who owns and lives in the property before the sale.

If the home is sold while still married, and the couple files a joint tax return, they may qualify for the full $500,000 exclusion, assuming both meet the ownership and use tests (or one spouse meets the ownership test and both meet the use test).

If the home is sold after a divorce, the full $500,000 exclusion is no longer available. Instead, each ex-spouse may individually qualify for a $250,000 exclusion — but only if they meet the ownership and use tests on their own. This means each must have owned and lived in the property for at least two of the five years before the sale.

Importantly, if one spouse is awarded the home in the divorce and sells it later, the IRS allows that spouse to count the other spouse’s prior period of use toward the two-year residency requirement. This can help preserve eligibility for the $250,000 exclusion, even if the occupying spouse did not live in the home for a full two years after the divorce.

Divorcing spouses should carefully review these rules before deciding when and how to sell a jointly owned home. Refer to IRS Publication 523 for more detailed guidance or consult a qualified tax professional.

Death of a Spouse: What Happens to the Section 121 Exclusion?

If one spouse passes away, the surviving spouse may still be able to claim the full $500,000 capital gains exclusion — but only for a limited time and under specific conditions.

Under IRS rules, if the home was jointly owned and the surviving spouse has not remarried, they may qualify for the full $500,000 exclusion if:

• The home is sold within two years of the spouse’s death, and
• The couple would have qualified for the $500,000 exclusion if the home had been sold jointly on the date of death

After the two-year window passes, or if the surviving spouse remarries before selling, the exclusion typically reverts to the $250,000 individual limit.

This rule provides some flexibility for widowed homeowners who wish to sell but need time to handle the emotional and practical aspects of the transition.

Note: The surviving spouse must still meet the ownership and use tests — either individually or based on the couple’s prior shared history in the home. For example, if the deceased spouse had met the ownership test, that can still apply.

For more details, refer to IRS Publication 523 or speak with your tax advisor, especially if there are additional complexities such as trusts, community property step-up rules, or inherited interests.

Selling a Duplex (Multi-Unit) and Claiming the IRS 121 Exclusion: What If You Lived in One Unit and Rented the Other?

If you own a multi-unit property such as a duplex, triplex, or fourplex — and you lived in one of the units as your primary residence while renting out the other(s) — the IRS allows a split treatment under Section 121. Here’s how it works:

• The portion of the property you used as your primary residence (e.g., Unit A of a duplex) may qualify for the Section 121 exclusion of up to $250,000 (single) or $500,000 (married filing jointly) — assuming you meet the ownership and use tests for that portion.
• The rental portion (e.g., Unit B of the duplex) does not qualify for the exclusion. Instead, any gain on that portion is generally taxable and may be subject to:
  • Long-term capital gains tax, and
  • Depreciation recapture, taxed at a higher 25% rate

You must allocate the gain (and basis) between the residential and rental portions of the property. This allocation is typically based on square footage or fair market value, depending on how the property was used and valued.

Example of Multi-Unit Property Sale and the 121 Exclusion:

You own a duplex and live in one 1,000-square-foot unit while renting out the other 1,000-square-foot unit. When you sell the entire property:

• 50% of the property (the unit you lived in) may qualify for the Section 121 exclusion.
• The other 50% (the rental unit) is taxable and subject to capital gains and depreciation recapture rules.

This approach can offer substantial tax savings — but also introduces complexity. It’s crucial to work with a tax advisor to properly allocate gains, especially if improvements, depreciation, or partial personal use have occurred over the years.

What are Capital Gains Taxes? 

Generally speaking, any ‘profit’ on the sale of your primary residence (i.e. the difference between what you paid for it, and what you sell it for, less expenses and other allowable deductions) will be taxed as “capital gains.”  

Capital Gains Taxes are simply another tax.  Even though the money you used to purchase the property and make the mortgage payments were already taxed, there are additional taxes now due at the time of sale, called “capital gains.”  

So, if you purchased your home for $100,000 and sold it many years later for $1,000,000, you essentially have $900,000 in “capital gains” on that sale.  

The IRS Section 121 exclusions are significant potential savings; but, if your profit is well over those allowances, you will still owe capital gains taxes, potentially significant amounts.  This fear of taxation is one of the many factors contributing to our tight housing supply, i.e. people do not want to sell knowing they will have to pay capital gains taxes on their profits, even if they buy a new home.

What are Capital Gains Tax Rates? 

Long-term capital gains tax rates for the 2025 tax year are as follows: 

(Note – Long-term capital gains are taxed at preferential rates, but your total taxable income — including the capital gain — determines which capital gains rate applies. While only the gain itself is subject to these rates, your other income can push the gain into a higher bracket. Your remaining income is still taxed under regular income tax rules.)

Single Filers:

• Up to $48,350 – 0% capital gains tax rate
• $48,351–$533,400 – 15% capital gains tax rate
• Over $533,400 – 20% capital gains tax rate

Married Filing Jointly:

• Up to $96,700 – 0% capital gains tax rate
• $96,701–$600,050 – 15% capital gains tax rate
• Over $600,050 – 20% capital gains tax rate

Head of Household:

• Up to $64,750 – 0% capital gains tax rate
• $64,751–$566,700 – 15% capital gains tax rate
• Over $566,700 – 20% capital gains tax rate

These 2025 thresholds reflect adjustments for inflation and are slightly higher than the 2024 thresholds.

Need 2024 numbers – check out our article on 2024 capital gains rates here.

Thus the highest federal capital gains rate is currently 20%.

Don’t Forget The Affordable Care Act, aka “Obamacare” Tax

On top of that, The Affordable Care Act, aka “Obamacare” imposed a Medicare Tax on long term capital gains for high income earners, those with a modified adjusted gross incomes over $200,000 for individuals and $250,000 for married couples of an additional 3.8%.

Don’t Forget The California (or other state) Tax

Additionally, California (and some other states) will want their tax too! California will treat the capital gains as ordinary income for tax purposes (i.e. it just gets added on top of whatever else you make, and the total amount is treated as your taxable income). The greater the amount, the greater the risk of being pushed into California’s highest tax bracket of 13.3%.

(Note, the top California income tax rate effective January 1, 2024, is an eye-watering 14.4%. The new 14.4% rate is the result of no limit on California’s 1.1% employee payroll tax for State Disability Insurance. Thus a 14.4% rate for those earning over $1 million. However, this would not apply to a home sale, so it’s “only” the 13.3%. Phew.)

Therefore, the worst case, for high profits (or high earners) in California, capital gains taxes are up to 37.1%. That’s over a full one-third of the gain, out the window, in taxes.

What Else Can I Deduct To Reduce My Capitals Gains Exposure: Improvements and Expenses 

You can further reduce that amount by excluding certain expenses and other allowable deductions, such as capital improvements to the home, if any, and selling expenses such as REALTOR fees, escrow and title fees and the like. 

“Improvements” generally add to the value of your home, prolong its useful life, or adapt it to new uses, such as room additions and modernization like kitchen or bathroom remodels or electrical upgrades.

Here are some specific examples from the IRS of what DOES count as improvements:

• Additions to Bedroom, Bathroom, Deck, Garage, Porch or Patio
• Lawn & Grounds such as Landscaping, Driveway, Walkway, Fence, Retaining wall and Swimming pool
• Systems such as Heating system, Central air conditioning, i.e. HVAC, Furnace, Duct work, Central humidifier, Central vacuum, Air/water filtration systems, Wiring, Security system, Lawn sprinkler system
• Exterior work such as Storm windows/doors, New roof, New siding, Satellite dish
• Insulation in the Attic, Walls, Floors, Pipes and duct work
• Plumbing such as Septic system, Water heater, Soft water system and Filtration system
• Interior work such as Built-in appliances, Kitchen modernization, Flooring, Wall-to-wall carpeting and Fireplace

New paint may not qualify, but some “repairs” may qualify if done as part of a larger project to improve the home. Refer to IRS Publication 523 for a complete list of improvements that may qualify, citations below. 

Expenses such as Fees and Closing Costs are deductible.

Here are some specific examples from the IRS of what DOES count as fees and costs you can include to reduce your basis on the sale of the home:

• Any sales commissions (for example, a real estate agent’s sales commission),
• Any advertising fees,
• Any legal fees,
• Any mortgage points or other loan charges you paid that would normally have been the buyer’s responsibility,
• Any other fees or costs to sell your home

Here are some specific examples from the IRS of what DOES count as fees and costs you can include to reduce your basis on the initial purchase of the home:

• Abstract fees (abstract of title fees),
• Charges for installing utility services,
• Legal fees (including fees for the title search and preparing the sales contract and deed),
• Recording fees,
• Survey fees,
• Transfer or stamp taxes,
• Owner’s title insurance, and
• Certain Costs owed by the seller that you paid. You can include in your basis any amounts the seller owes that you agree to pay (as long as the seller doesn’t reimburse you), such as: Any real estate taxes owed up through the day before the sale date, Back interest owed by the seller, The seller’s title recording or mortgage fees, Charges for improvements or repairs that are the seller’s responsibility (for example, lead paint removal), and Sales commissions (for example, payment to the seller’s real estate agent).

Therefore most sellers will have some additional deductions to calculate and may need to dig through old receipts to add up their improvements to the property over the years.  

What If You Don’t Have Receipts for Improvements or Purchase Costs?

1. Start with Your Closing Statement

For the original purchase, your HUD-1 Settlement Statement or Closing Disclosure often includes many allowable costs that can increase your basis. Look for:

• Title insurance
• Escrow fees
• Recording fees
• Transfer taxes
• Legal fees
• Survey fees

Tip: Ask your escrow or title company for a copy if you’ve lost yours. Many keep records for years.

2. Search Bank & Credit Card Statements

Even if you don’t have detailed receipts, large expenses (e.g., roof replacement, HVAC, remodels) often show up in:

• Bank account history
• Credit card transactions
• Checks written (especially if you used a contractor)

Tip: Look for vendor names (e.g., “Lowe’s,” “Home Depot,” “ABC Roofing Inc.”) and approximate dates, then reconstruct based on typical costs at the time.

3. Use Permits to Reconstruct Improvements

If major work was done (e.g., kitchen remodel, additions, electrical rewiring), you may have:

• Building permits on file with the city
• Contractor records, even years later

Tip: Contact your city’s building department for copies of past permits. They often show dates, job type, and contractor info.

4. Reasonable Estimates Are Permitted — If Well-Documented

The IRS does not require exact receipts, but it does require reasonable substantiation. “If you do not have exact records, you must use reasonable estimates that can be supported by other documentation.”
(Pub 17, “Proof of Expenses” section). Moreover, in Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), the Tax Court established that when a taxpayer lacks documentation, the IRS or court may allow a reasonable estimate, provided it is not arbitrary and is based on credible evidence. This is called the “Cohan Rule,” and it’s widely cited by the Tax Court to this day.

That means:

• You can reconstruct costs based on credible evidence.
• Document why you believe a certain number is accurate (e.g., estimate based on contractor bid, market rates at the time, or similar recent projects).
• Keep a log or memo explaining how you derived the numbers.

Tip: The IRS has accepted detailed estimates, especially when made in good faith and not overstated.

5. Photographs and Appraisal Reports Can Help

Photos taken before and after improvements, and notes from appraisers, can be used to support the existence and nature of improvements.

Example: A pre-listing appraisal that references a new roof or upgraded kitchen supports your claim even if you can’t locate the receipt.

6. Don’t Claim What You Can’t Reasonably Defend

It’s better to leave out a questionable $8,000 project than to claim it without support and raise red flags. The IRS may disallow undocumented deductions if they appear fabricated or excessive.

Summary For Situations Where You Don’t Have Receipts for Improvements or Purchase Costs?

Don’t have perfect records? That’s common — and the IRS understands this. If your receipts are lost or incomplete, the IRS allows you to use reasonable estimates based on other credible documentation such as bank statements, credit card records, or building permits. This concept — known as the “Cohan Rule,” from a foundational Tax Court case — permits taxpayers to reconstruct basis and deductions when records are missing, as long as the estimate is made in good faith and backed by some evidence. Refer to IRS Publications 17, 523, and 583, and the case of Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), for more details.

How Do I Avoid Capital Gains Taxes?  

There’s no magical solution here, but some tax strategies such as installment sales, structured installment sales, and opportunity zones can reduce or defer the tax obligations. 

A 1031 exchange remains a gold standard and likely the best real estate tax incentive available, but that only applies to investment properties, not a primary residence.  Though there are ways to utilize the 1031 exchange with long-term planning.  See our 1031 article(s) for more information (link to 1031 article here).  https://lucas-real-estate.com/1031-exchange-overview/

Beyond that, call your state and federal elected officials and let them know your thoughts on capital gains taxes.  Pay attention to political candidates’ positions on tax policy when voting if these issues concern you. 

Examples of IRS Section 121 Application

Example 1:

If you are married and purchased your home for $1,300,000 and sell it for $1,700,000, and you qualify for the 121 exclusion (since you both lived in and both owned the home for more than the past two years), you will owe zero capital gains taxes. (i.e. $400,000 gross profit [$1,700,000 – $1,300,000], less the $500,000 exemption is greater than the profit, so no capital gains taxes due).

Example 2:

If you are single and purchased your home for $300,000 and sell it for $700,000, and you qualify for the 121 exclusion (since you lived in and owned the home for more than the past two years), you will owe capital gains taxes on $150,000. (i.e. $400,000 gross profit [$700,000 – $300,000], less the $250,000 exemption, is $150,000).

Example 3:

If you are married and purchased your home for $300,000 and sell it for $700,000, and you qualify for the 121 exclusion (since you both lived in and both owned the home for more than the past two years), you will owe zero capital gains taxes. (i.e. $400,000 gross profit [$700,000 – $300,000], less the $500,000 exemption is greater than the profit, so no capital gains taxes due).

Example 4: 

If you are single and purchased your home for $500,000 and sell it for $700,000, but you only purchased the home one year ago, and you are therefore not eligible for the 121 exclusion, you will owe taxes on the entire $200,000 profit.   (i.e. $200,000 gross profit [$700,000 – $500,000], no exemption, thus the entire profit is subject to capital gains taxes).

Rolled Over Prior to 1997?

As noted, these rules have been in place since 1997.  Prior to 1997, different rules applied that let homeowners avoid capital gains taxes by rolling their profits into another home, as long as the purchase price of the new house was equal to or greater than the home they sold.  If you did sell a home and roll over prior to 1997, and now sell, you may essentially owe those deferred taxes back by a reduction in the tax basis of your current home by the amount of taxes rolled over.  For example, if you rolled $200,000 of capital gains from previous home sales into your current home, $200,000 would be subtracted from your tax basis on this home (i.e. you are exposed to that additional $200,000 in “capital gains” on this sale). 

Questions or Need Help?

Thinking of selling California real estate, we would love the opportunity to assist – we provide full service sales in Newport Beach, Costa Mesa and surrounding areas. If you are seeking to sell your home in Newport Beach, Costa Mesa or the surrounding areas, call or email anytime for a free brief consultation – info@lucas-real-estate.com or 949-478-1623.

We provide advice and consultation for sales throughout the state of California. Call or write anytime or book a consultation. Paid one-hour confidential legal consultations are conducted daily via Zoom and address virtually all questions, options, tax implications and strategies. (Book a consultation here.)

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– Devin Lucas

Author Devin R. Lucas is a Real Estate Broker, REALTOR® and Real Estate Attorney specializing in Newport Beach, Costa Mesa, and Orange County coastal communities. Courtney Lucas, a licensed CPA, Real Estate Salesperson, and REALTOR®, provides expert financial insight alongside real estate services. Together, they lead Lucas Real Estate, operating in conjunction with Coldwell Banker, the region’s premier luxury brokerage.

Lucas Real Estate offers unmatched expertise in California real estate sales, capital gains strategies, and property tax matters, including Propositions 13, 58, 193, 60, 90, and new Proposition 19.

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