Depreciation Recapture Reduces Section 121 Exclusion on Home Sale

You can still use the home sale exclusion when you sell a main home that you also used for business or rented out. To qualify, you must meet both the ownership and use tests under Section 121 of the Internal Revenue Code. That means you must have:

• Owned the home for at least 2 years during the 5 years before the sale, and
• Lived in it as your main home for at least 2 years during the same 5‑year period.

The maximum exclusion is $250,000 for single filers and $500,000 for married couples filing jointly. These limits still apply in 2025. However, if you took (or could have taken) depreciation for business use or rental of the home after May 6, 1997, you cannot exclude the part of your gain that is attributable to that depreciation. That portion is taxed as unrecaptured Section 1250 gain at a maximum rate of 25%.

According to analysis by VisaVerge.com, no major changes to these rules were reported in 2024–2025, and the IRS continues to apply them as written.

How the rules work — key points

1) Depreciation reduces basis and increases taxable gain

• If you used the home for business or rental, you likely claimed depreciation. Even if you didn’t claim it, but you were allowed to, you must reduce your basis by the amount that was allowable.
• You cannot exclude the part of the gain equal to depreciation allowed or allowable after May 6, 1997.
• If your records show you claimed less than what was allowable, the amount you cannot exclude is the amount you actually claimed.

2) Allocation for nonqualified use

• Time when the home was not your main home (for example, rental periods) may be treated as nonqualified use.
• The gain tied to nonqualified use can’t be excluded and is taxed as long‑term capital gain (up to 20%).
• Certain periods are not counted as nonqualified use, including some time within the final 5 years before the sale and periods tied to qualified official extended duty (military, Foreign Service, intelligence community), as described by the IRS.

3) Reporting requirements

• The portion connected to depreciation (the business/rental portion) is reported on Form 4797 (Sale of Business Property).
• The remaining portion of the sale is reported on Form 8949 and Schedule D (capital gains and losses), after you figure the Section 121 exclusion, the depreciation recapture, and the nonqualified‑use share.

Important: Depreciation recapture rules and nonqualified use allocations can significantly change your tax outcome. Keep good records.

Example with numbers

Liam bought his home for $250,000. He later rented it and claimed $50,000 in depreciation. He sells it for $450,000.

• Adjusted basis: $250,000 − $50,000 = $200,000
• Total realized gain: $450,000 − $200,000 = $250,000
• Depreciation portion (unrecaptured Section 1250 gain): $50,000 (taxed up to 25%)
• Net gain after removing depreciation portion: $250,000 − $50,000 = $200,000
• Nonqualified use portion (assume 20%): $40,000 (taxed up to 20%)
• Remaining gain that can be excluded under Section 121: $160,000

Totals in this example:
– $50,000 unrecaptured Section 1250 gain (depreciation)
– $40,000 long‑term capital gain (nonqualified use)
– $160,000 excluded under Section 121
– $250,000 total gain

Documents to keep and forms to file

Good records protect your exclusion and prove the correct depreciation amount if the IRS asks. Keep clear, dated documentation:

• Settlement statements for purchase and sale (closing disclosures)
• Proof of improvements and dates (receipts, contracts)
• Dates you lived in the home and dates you rented or used it for business
• Depreciation schedules and yearly tax returns that show depreciation claimed
• Records that show any time periods that are not treated as nonqualified use

Forms you may need (official links):
– Form 4797 (Sale of Business Property) for depreciation recapture: https://www.irs.gov/forms-pubs/about-form-4797
– Form 8949 (Sales and Other Dispositions of Capital Assets): https://www.irs.gov/forms-pubs/about-form-8949
– Schedule D (Form 1040), Capital Gains and Losses: https://www.irs.gov/forms-pubs/about-schedule-d-form-1040

Authoritative IRS guide (single required external link):
– IRS Publication 523, Selling Your Home (2024/2025 update): https://www.irs.gov/forms-pubs/about-publication-523

Step-by-step process to calculate and report

1. Check you meet both tests
   • Confirm you pass the 2‑out‑of‑5 years ownership and use tests.
2. Figure adjusted basis
   • Start with what you paid for the home.
   • Subtract total depreciation allowed or allowable since May 6, 1997.
   • Add allowed improvements (not repairs).
3. Compute total gain
   • Sale price minus selling costs (commissions, etc.) minus adjusted basis.
4. Separate the depreciation portion
   • The amount equal to total depreciation is taxed as unrecaptured Section 1250 gain (max 25%).
   • Report this on Form 4797.
5. Allocate the remaining gain between qualified and nonqualified use
   • Apply the nonqualified use fraction (based on time) to the remaining gain.
   • That nonqualified‑use part is long‑term capital gain (max 20%).
   • The remainder can be excluded under Section 121 up to the $250,000 / $500,000 limit.
6. Report correctly
   • Use Form 4797 for recapture.
   • Use Form 8949 and Schedule D for the capital gain part and the exclusion.

Practical tips and common pitfalls

• Track depreciation from day one. If you used any part of the home for business or rental, keep a simple log and save yearly tax returns.
• Remember that “allowable” depreciation counts even if you didn’t claim it—this often surprises sellers.
• Don’t mix repairs with improvements—only improvements increase basis.
• Keep a calendar of use. Clear dates help compute nonqualified use.
• Watch the 5‑year window. Selling before you meet the 2‑year use test can cost you the exclusion.
• If you switched from rental to main home before selling, check the rules that can exclude some late periods from nonqualified use.
• Use the IRS worksheets in Publication 523 to do the math carefully.
• When in doubt, get professional help before listing the home—fixing record gaps after closing is harder.

Policy status and where to confirm

As of August 15, 2025, the IRS has not announced major changes to Section 121 rules for mixed‑use homes. IRS Publication 523 (2024 edition, updated February 2025) explains the ownership and use tests, the depreciation rule after May 6, 1997, unrecaptured Section 1250 gain, nonqualified use, and which forms to file. VisaVerge.com reports that tax professionals continue to emphasize correct tracking of depreciation and careful allocation between personal and rental/business periods to avoid underpayment.

Key takeaway: Maintain precise records of use, improvements, and depreciation. That documentation will determine how much gain is excluded, how much is recaptured as unrecaptured Section 1250 gain, and what portion (if any) is taxable as long‑term capital gain.