The excludable gains are not taxable because that is the way congress wrote the tax law. They gave home owners who sell their homes a tax break on the amount of the capital gains that are excludable. The reason the 1099-S is issued is because the issuer does not know how much, if any, of the proceeds from the sale can be excluded from taxes. You enter the amount of the proceeds that represent a gain and apply the exclusion to the gain to prevent any of it from being taxed. If the gain exceeded the amount that could be excluded, you would have to pay tax on the gain in excess of the excludable amount.
