Rental History Can Reduce the Home-Sale Tax Break, Leaving Former Landlords Owing

A retired couple selling a home with a $430,000 gain expected the $500,000 Section 121 exclusion to eliminate tax. Because the property had three years of rental use, about $30,000 of gain remained taxable, largely through depreciation recapture, creating a federal bill up to $7,500. The IRS counts depreciation that was allowed or allowable, even if the owners did not claim it.

Section 121 lets eligible sellers exclude home-sale gain if they owned and lived in the property for at least two of the five years before selling; the limit is $250,000 for single filers and $500,000 for qualifying joint filers. A carve-out denies exclusion for depreciation after May 6, 1997, and Publication 523 tells former landlords to report that portion as unrecaptured Section 1250 gain.

In the example, a couple bought for $350,000, assigned $75,000 to land, rented for three years, and sold for $750,000. Depreciation over 27.5 years produced about $30,000, leaving $430,000 gain; $400,000 was excluded and $30,000 taxable, with maximum federal tax near $7,500. Publication 544 counts permitted depreciation, not merely amounts deducted.