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I am approaching the point where my house is worth about $500,000 more than my wife and I paid for it. I have a trusted friend who is in the same position.

IRS Publication 523 states that "You cannot exclude gain on the sale of your home if, during the 2-year period ending on the date of the sale, you sold another home at a gain and excluded all or part of that gain. If you cannot exclude the gain, you must include it in your income."

Thus, it appears to me that the $500,000 exclusion for capital gains can be used more than once as long as there is 2 years between the times that the exclusion is used. If that is true, what prevents my friend and me from selling our houses to each other in legitimately documented sales with title transfers, then renting our respective houses to each other (we each become the other's landlord). We then can each take the $500,000 exclusion on the gain. After 6 months or a year, we each sell our houses back to the other for what we paid. We then have a new basis and, if we stay in the houses for another two years after that, we can utilize the exclusion again if either of us finds it necessary to sell. Ignoring transaction costs, it seems to me to be a way to shelter the gain once you reach the limit of the exemption but do not intend to actually move out of your house. Even if one or the other were forced to sell within two years after that, he is no worse off, again ignoring transaction costs, than if the transaction had not taken place.

Is there something I am missing? It seems that if the sales are structured legitimately between non-related parties, it complies with the letter of the law, which I understand is what is required by the tax code.
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