A Costly Mistake: $500,000 Exclusion Denied
- Carina Luo
- Jun 22
- 3 min read
Discover the pitfalls that can jeopardize your Section 121 exclusion—and how to protect your tax savings.
If you're a homeowner thinking about selling, there's a powerful tax benefit you should know about: the Section 121 exclusion. This provision lets you avoid paying capital gains tax on up to $250,000 (or $500,000 if married filing jointly) of profit from the sale of your primary residence. But the rules are specific—and mistakes can be costly.
Let me share a story about a couple who lost out on the full $500,000 exclusion because they didn’t understand the timing rules.
A Costly Mistake: $500,000 Exclusion Denied
One couple came to us after selling a home they had lived in for many years but had converted to a rental property for the last three and a half years. They assumed they would still qualify for the Primary residence exclusion and were frustrated when their previous CPA reported the full capital gain without applying the $500,000 exclusion.
Unfortunately, the IRS section 121 is clear: to qualify, you must have owned and used the property as your primary residence for at least 2 out of the 5 years immediately before the sale. Because they had rented the home for more than three years, they no longer met the "2-in-5" rule at the time of sale.
Had they sold even six months earlier, they might have preserved their eligibility and excluded a significant portion of their gain. Instead, their timing error cost them hundreds of thousands of dollars in additional taxes.
What Is Section 121 Exclusion?
Section 121 of the Internal Revenue Code allows for a permanent exclusion of capital gains on the sale of your primary home:
$250,000 exclusion for single filers
$500,000 exclusion for married couples filing jointly
You must own and use the home as your primary residence for at least 2 out of the 5 years before selling
You can only claim the exclusion once every 2 years
Combining Section 121 with a 1031 Exchange (Rev. Proc. 2005-14)
If you’re converting your primary residence into a rental before selling, there’s a strategic way to potentially benefit from both Section 121 and a 1031 exchange:
Rent the property out for 12–18 months (but less than 3 years)
Claim Section 121 exclusion on the portion of the gain attributable to the time it was your primary home
Defer tax on the remaining gain and depreciation recapture using a 1031 exchange
This is a highly effective strategy for highly appreciated properties—but timing and execution are key.
Qualifying for Section 121 Starts Long Before You Sell
Don’t wait until you're ready to sell to start planning for the Section 121 exclusion. Your ability to claim this tax break depends on how the property is titled, who actually lives in it as their primary residence, and how long you lived in their as the primary residence. When ownership and use don’t align, both parties can lose out on this valuable benefit.
Common mistakes we see include:
Converting primary home to rental and blow 2-in-5" rule
Converting rental to primary home without knowing partial Section 121 exclusion
Reporting either too much exclusion, or complete miss the partial exclusion
Buying the property under foreign parents' names because they pay for a large down payment
Disqualifies the U.S. resident child from Section 121 exclusion
Triggers FIRPTA withholding (15% of the sale price) when for foreign owners
Adding children to the property title too early
Creates gift tax exposure
May lead to loss of control over the property
Opens risk if children divorce or are forced to sell
Take Action
Section 121 is one of the most generous and accessible tax breaks available to homeowners—but only if you understand and follow the rules.
Want to see if you qualify for a tax-free home sale? Or need help structuring a move from primary residence to rental property the right way? Book a strategy session with LightUp Tax today—and keep more of your hard-earned equity where it belongs: with you.
Reach out to LightUp Tax today to schedule your consultation and
secure your spot for 2025 tax compliance and planning!
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