A Retired Couple Expected Zero Tax on a $430,000 Gain. Three Years of Rental History Added a $7,500 Bill

Consider a retired couple in their late 60s selling the house where they raised their kids. They know the rule everyone knows: a married couple can exclude up to $500,000 of gain on a main home. Their gain is $430,000, so they set aside nothing for taxes.

Then their preparer finds a $30,000 piece of that gain the exclusion can’t cover, with a federal bill of up to $7,500. The reason is that the house spent three years as a rental before the sale. Landlords must account for every dollar of depreciation they took, and every dollar they could have taken.

Section 121 Has a Depreciation Carve-Out Most Sellers Miss

The home-sale exclusion is found in Internal Revenue Code Section 121. You qualify if you owned the home and used it as your principal residence for at least 2 years during the 5-year period ending on the sale date. The cap is $250,000 for single filers and $500,000 for qualifying joint filers.

The hole is Section 121(d)(6). It says the exclusion doesn’t apply to gain up to the amount of depreciation taken for periods after May 6, 1997. IRS Publication 523 spells out the result for former rentals: depreciation from the earlier rental years “must be reported on line 5a of Worksheet 2 and recognized as unrecaptured section 1250 gain.” That gain is taxed at your ordinary rate, capped at 25% under Section 1(h)(1)(E).

How $30,000 of Gain Slips Past a $500,000 Exclusion

Here’s the math for our example couple, filing jointly for tax year 2026. They bought in 2005 for $350,000 and allocated $75,000 of that to land, which can’t be depreciated. They lived there until mid-2023, moved to a condo and rented the house out for three years.

Residential rental property is depreciated over 27.5 years. That makes the $275,000 building basis worth about $10,000 a year. The math is simplified here and ignores the mid-month convention.

They pass the two-year test because they lived in the house for two of the five years before the sale. The rental years also came after they last lived there, and Section 121(b)(5)(C)(ii)(I) exempts that period from a second penalty. So the depreciation piece is their only cost. Some states tax it as well.

Skipping Depreciation Doesn’t Get Landlords Off the Hook

Some small landlords never claim depreciation because they want to keep their returns simple. That backfires. IRS Publication 544 says the amount that matters is “the greater of depreciation allowed or allowable,” and Pub. 523 applies the same standard to home sales. Skip the deduction, and you’ll still pay tax on a write-off you never used.

Landlords who missed depreciation can often claim it before the sale through an accounting-method change on Form 3115. Raise that with a CPA before the house goes on the market.

Renting First and Moving In Later Opens a Second Hole

The order matters. Rental years before you move in count as “nonqualified use” if they fall after January 1, 2009. The law splits the gain based on the portion of the ownership period those years represent, and that share gets no exclusion.

Say a couple owns a house for 10 years, rents it out for the first six and lives in it for the last four. Then 60% of the gain is taxable, matters after the depreciation piece comes off. On $400,000 of remaining gain, that’s $240,000 outside the exclusion, plus the depreciation recapture on top.

Rising prices make both holes larger. The Case-Shiller national home price index was up 1.9% year over year as of July 2026, its most recent reading.

Three Moves That Can Shrink the Depreciation Bill

1. Rebuild your records now. Pull the closing statement, the land and building split and every Schedule E. The recapture is calculated from them, and the IRS will assume you took the full allowed amount anyway.
2. Sell in a low-income year. The 25% figure is a ceiling. In a lean year, such as the stretch between retirement and required minimum distributions, the depreciation piece may be taxed at a much lower ordinary rate.
3. Consider holding the house versus selling it. Under Section 1014(a), heirs take a basis equal to the fair market value of the property at the date of the decedent’s death. That generally wipes out the built-in gain, depreciation included. Former landlords who want to stay landlords can also look at a like-kind exchange but only while the house is a rental or held for investment.

Run that math with a CPA or trusted tax advisor before you list the house.

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