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First - is this correct?

Generally, yes.

Second - what is the strategy to get the tax consequence reduced?

Sell the house. Take the 121(g) exclusion to get some tax-free gains. Buy something else with the proceeds. Rent that property out. Better yet, buy something more like an investment property. Maybe a 4 or more unit building. Sounds like a good opportunity to lever up into a larger property that would provide more long-term income and growth than an overpriced (relative to the rent collected) single family residence. The basis will be the current market value rather than those of 1985, so there will be some measurable depreciation to shelter the cash flow.

He is living with some one - not married. I thought possibly sell it to her? would that work?

I wouldn't touch that with the proverbial 10 foot pole. Smells too much like a transaction with tax avoidance as the main purpose.

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