In the United States, for federal income tax purposes, the capital gain realized in the sale of a rental property is usually taxable. But there is one exception: Primary residence rented out after moving out if done right.

What is a Capital Gain in a Real Property Sale?

Unlike what many people may have thought, the capital gain in a real property sale is not the full sale price or proceeds. This gain characterizes how much income the seller has generated by purchasing the property, optionally making improvements, and selling it later. The capital gain in such a sale is typically the selling price minus the purchasing price, the cost to improve the property, and various closing costs. Closing costs include sales commissions paid to real estate agents, real property transfer tax, etc.

The Tax Benefit Offered by Section 121

If the owner has been living on the property and sells it later, Section 121 of the Internal Revenue Code may offer one potential tax benefit: $250k (or $500k if filing jointly) of the capital gain is excluded from federal income taxation. This tax benefit is commonly referred to as the Section 121 exclusion. To be eligible for the Section 121 exclusion, unless an exception applies, one must have been living on the property for 2 of the past 5 years. Additionally, if the owner has rented out the property before living in it, additional restrictions apply.

Can We Apply the Section 121 Exclusion to Rental Properties?

As stated at the beginning of this article, the gain realized in the sale of a rental property is subject to federal income taxation. Can we bring the benefit of the Section 121 exclusion to a rental property?

The answer is yes, but only if it is done right. After moving out from a primary residence that satisfies the requirements of the Section 121 exclusion, the owner can rent out the primary residence as a rental property. However, the owner must sell it before losing the eligibility of the Section 121 exclusion. In other words, the owner can still reap the full benefit of the Section 121 exclusion if:

  • the owner has been living on the property for the whole 2 years before moving out;
  • the owner rents out the property after moving out; and
  • the owner sells it before the third anniversary of the moving out date.

Estimate the Annualized Return

The following calculator estimates the annualized return of renting out the primary residence after moving out. The calculator assumes that:

  • The owners have been living in their primary residence for the whole 2 years before moving out.
  • The owners rent out the property for 3 years immediately after moving out.
  • The owners close the sale before the third anniversary of the moving out date.
  • The owners had never rented out their primary residence before they started living there.