How to Legally Avoid Capital Gains (and Minimize Depreciation Recapture) by Living in Your Minneapolis Duplex

If you own a Minneapolis or St Paul duplex and you’re not using the 2-out-of-5-year rule, you’re leaving one of the biggest legal tax advantages in real estate on the table.

This isn’t a loophole. It’s called Section 121, and when paired with a duplex or triplex, it’s one of the most powerful wealth-building tools available to small multifamily owners.

The rule states if you live in a property as your primary residence for at least 2 of the last 5 years, you can exclude:

• Up to $250,000 in capital gains if you’re single
• Up to $500,000 if you’re married filing jointly

That part gets talked about a lot. What gets talked about less is this it applies to the portion of the property you lived in. With a duplex, that matters—a lot.

Why?  Let’s say you own a standard side-by-side or up-down duplex:

• You live in one unit
• You rent out the other unit
• You do this for 2 of the last 5 years
• Then you sell

Capital Gains Treatment

When you sell, the IRS looks at the property as two components: Your owner-occupied unit and the rental unit

The gain is allocated—typically by square footage or unit count. The portion you lived in qualifies for the Section 121 capital gains exclusion. The rental portion does not.

That means you can often exclude half (or more) of the capital gain entirely.

What about depreciation recapture? Unfortunately, depreciation recapture is not eliminated by the 2-out-of-5 rule.  Any depreciation you claimed on the rental portion is still recaptured and taxed at up to 25%

However…this may still work in your favor.

Depreciation is recaptured on the rental portion, not the unit you lived in. This isn’t necessarily bad news. Many duplex owners under-depreciated early on. Or, they may have owned the property so long that decades ago there were different depreciation schedules. They may also have made significant capital improvements that reset their basis.

After you’ve lived in one unit for two years, what would happen if you moved into they other? If you lived there two years, then sold the following year, you would have lived in each of the units two of the last four years. For the record, the two years do not need to be consecutive. They can be a month here, six months there, just so it adds up to a total of two of the last five years.

If you do that, you’ve eliminated capital gains tax. And you don’t have any depreciation on the unit you originally lived in.

Of course, I’m not an accountant, and you should always speak with one before you make big decisions like selling a duplex you’ve owned a long time.

If you own a duplex—or are thinking about selling one—do not list it until you’ve asked this question:

“Would living in this unit for two years save me six figures in taxes?”

Sometimes the answer is yes. And when it is, the smartest move isn’t upgrading kitchens or timing the market.

It’s changing which door you use.