Understanding the Homeownership Exemption—and What to Do If You Have Too Much Equity

If you’ve owned your home for several years—especially in a high-appreciation market like San Diego—you may be sitting on a significant amount of equity. While this is generally a good problem to have, it can present a tax challenge when it’s time to sell. Understanding how the homeownership exemption works, what your options are, and where recent tax law changes fit in is essential before making your next move.

What Is the Homeownership Exemption?

The IRS allows homeowners to exclude a portion of capital gains from the sale of their primary residence. This is commonly known as the Section 121 exclusion. To qualify, you must meet the ownership and use test, meaning you have:

• Owned the home for at least two years, and

• Lived in the home as your primary residence for at least two of the past five years.

If you qualify, you may exclude up to $250,000 in capital gains if you're single, or $500,000 if you’re married and filing jointly. This exclusion is not a deduction—it’s an outright exemption from tax.

When You Have More Equity Than the Exemption Allows

In today’s market, especially in California coastal regions, it’s not uncommon for homeowners to exceed the $250,000 or $500,000 exemption thresholds. In that case, the excess amount is typically subject to federal capital gains tax, and possibly state tax depending on your location.

Here are a few strategic considerations:

1. Track and Increase Your Cost Basis

Your capital gain is calculated as the difference between your sale price and your adjusted cost basis. Many homeowners forget they can add the cost of home improvements—such as room additions, new roofs, or kitchen remodels—to their basis. Keeping good records could help reduce your tax bill significantly.

2. Use the 1031 Exchange—With Caution

A 1031 exchange allows you to defer capital gains tax by reinvesting proceeds from one investment property into another. However, this strategy does not apply to your primary residence. If you’ve converted your home into a rental before selling, you may explore this route, but it requires careful timing and IRS compliance. Always consult a tax advisor if you're considering this option.

3. Consider Converting to a Rental First

One way to access 1031 advantages is to convert your primary residence into a rental property, then wait a period of time before selling. After a sufficient rental period, it may qualify as investment property—making it eligible for a 1031 exchange. But this strategy comes with IRS scrutiny, and again, professional advice is key.

4. Time Your Sale Strategically

If you're married and close to a divorce or separation, it may be worth selling while you can still jointly claim the $500,000 exemption. Similarly, if you plan to move in with a partner, timing your sale for maximum tax advantage could be wise.

A Note on the SALT Cap and the “Big Beautiful Bill”

Recent legislation—referred to by some as the “Big Beautiful Bill”—included revisions around the State and Local Tax (SALT) deduction cap, raising it in certain cases. However, it’s important to understand: the SALT deduction has no impact on capital gains exclusions or liabilities. These changes help some homeowners on annual income tax, but do not apply to profits from home sales.

Always Consult a Tax Advisor

Every situation is different. Your filing status, income, state of residence, home improvements, and timing of sale all affect what you'll owe. The best course of action is to consult a qualified tax advisor or CPA before selling. They can help you navigate available exemptions, optimize your cost basis, and plan strategically to minimize your tax burden.

You Don’t Have to Navigate This Alone

Whether you're thinking of selling, downsizing, or reinvesting, Team Hanna is here to help you evaluate your housing options in light of your financial goals. With strong local expertise and a trusted network of tax and legal professionals, we’ll help you make confident, informed decisions every step of the way.

Need help figuring out your next move?
Reach out here and let us know how we can help—we’re ready when you are.