Section 121 Exclusion and Rental 2026: What Happens When You Sell a Former Rental

The Section 121 exclusion lets a seller exclude up to $250,000 in capital gain from the sale of a primary residence, or $500,000 for married couples filing jointly. To qualify, the owner must have owned and used the home as their primary residence for at least two of the five years immediately preceding the sale. The complication for MLO clients arises when the property was previously or partially used as a rental.

Depreciation Recapture Is Not Excluded

Even if the total gain qualifies for the Section 121 exclusion, depreciation taken during any rental period must be recaptured and taxed at a maximum rate of 25%. If a client claimed $40,000 in depreciation over five years of rental use, they owe tax on that $40,000 regardless of the overall gain exclusion. This recapture is unavoidable under current tax law and is separate from the capital gain calculation.

Non-Qualified Use Reduction

• ✦Rental periods after December 31, 2008 are considered non-qualified use periods
• ✦The Section 121 exclusion is reduced proportionally by the fraction of time the property spent in non-qualified use
• ✦Example: property owned for 10 years, rented for 3 years after 2008, then occupied as a primary residence for 7 years; 30% of the gain is taxable as non-qualified use gain
• ✦Rental use before the property first became a primary residence counts fully toward the non-qualified use reduction

House Hacker Implications

Clients who live in one unit of a duplex and rent the other are subject to partial exclusion rules. The portion of gain attributable to the rental unit is not eligible for the full Section 121 exclusion and is subject to depreciation recapture. The allocation depends on the square footage split between owner-occupied and rented portions. Encourage clients to consult a CPA before selling any property that had any rental history.