The exclusion of up to $500,000 of capital gains on the sale of a primary residence under IRC Section 121 is one of the most generous tax preferences available under the tax code, due in no small part to the fact that most people only have occasion to sell their home and harvest such gains a few times in a lifetime.

However, for those who also invest in rental real estate, the capital gains exclusion on the sale of a primary residence creates an appealing tax planning opportunity – to convert rental real estate into a primary residence, in an effort to take advantage of the capital gains exclusion to shelter all of the cumulative gains associated with the real estate. And since the Section 121 exclusion can be used as often as once every 2 years, the planning opportunity is quite significant for those with large rental real estate holdings.

To prevent abuse of this planning scenario, Congress has enacted several changes to IRC Section 121 over the past 15 years, preventing depreciation recapture from being eligible for favorable treatment, requiring a longer holding period for rental property acquired in a 1031 exchange, and more recently forcing gains to be allocated between periods of “qualifying” and “nonqualifying” use. Nonetheless, some opportunities remain for real estate investors who do have the flexibility to change their primary residence in an effort to shelter capital gains on long-standing real estate properties.

Rules For Excluding Gain On Sale Of Residence

The Taxpayer Relief Act of 1997 created IRC Section 121, which allows a homeowner is allowed to exclude up to $250,000 of gain on the sale of a primary residence (or up to $500,000 for a married couple filing jointly). In order to qualify, the homeowner(s) must own and also use the home as a primary residence for at least 2 of the past 5 years. In the case of a married couple, the requirement is satisfied as long as either spouse owns the property, though both must use it as a primary residence to qualify for the full $500,000 joint exclusion.

Notably, the use does not have to be the final 2 years, just any of the past 2-in-5 years that the property was owned. Thus, for instance, if an individual bought the property in 2010, lived in it until 2012, moved somewhere else and tried to sell it, but it took 2 years until it sold in 2014, the gains are still eligible for the exclusion because in the past 5 years (since 2010) the property was used as a primary residence for at least 2 years (from 2010-2012). The fact that it was no longer the primary residence at the time of sale is permissible, as long as the 2-of-5 rule is otherwise met.

If a sale occurs and it has been less than 2 years, a partial exclusion may still be available if the reason for the sale is due to a change in health, place of employment, or some other “unforeseen circumstance” that necessitated the sale. In such scenarios, a pro-rata amount of the exclusion is available; for instance, if an individual had to sell the home after 18 months instead of the usual 24, the available exclusion would be 18/24ths multiplied by the $250,000 maximum exclusion, which would provide a $187,500 maximum exclusion (which will likely still be more than enough, as it’s unlikely that the gain would be more than this amount unless it was an extremely large house!).

To the extent that a property is highly appreciated, and there is a gain in excess of the available exclusion. The gain will be subject to the usual capital gains brackets, including the new top 20% rate and the new 3.8% Medicare surtax, if total income is high enough for the capital gain to fall across the applicable thresholds.

Example 1. Max and Jenny, a married couple, bought a home decades ago for $250,000, and are now selling it for $900,000. Their total gain is $650,000, and they have easily met the 2-of-5 ownership-and-use requirement. As a result, they can exclude $500,000 of the capital gains. The remaining $150,000 capital gain – eligible for long-term capital gains treatment, as the holding period is far beyond the 12-month requirement – will be reported on their tax return as a normal long-term capital gain, subject to the usual tax rates (and potential 3.8% investment income surtax) that may apply.

The capital gains exclusion is only allowed once every 2 years. Thus, the partial exclusion still cannot be used if another exclusion had been claimed for another sale in the past 24 months, and in the event of a married couple the full $500,000 exclusion is only available as long as neither spouse has used it in the past 2 years (if one spouse sold a home recently and the other did not, the second spouse can still use his/her individual $250,000 exclusion). On the other hand, as long as “no more than once every 2 years” requirement is met, there is no limit on home many times an individual can take advantage of the primary residence capital gains exclusion throughout their lifetime!

Converting A Rental Property Into A Primary Residence

For most people, the exclusion of capital gains on the sale of a primary residence is something that only comes along a few times throughout their lifetime, as individuals and couples move from one home to the next as they pass through the stages of life. However, because the exclusion is available as often as once every 2 years, some homeowners may even try to sell and move and upgrade homes more frequently, to continue to “chain together” sequential capital gains exclusions on progressively larger homes (presuming, of course, that the real estate prices continue to rise in the first place!). However, in some cases taxpayers decided to go even further, taking long-standing rental property, moving into it as a primary residence for 2 years, and then trying to exclude all of the cumulative gains from the real estate (up to the $250,000/$500,000 limits), even though most of the gain had actually accrued prior to the property’s use as a primary residence! The opportunity is especially appealing in the context of rental real estate, as the potential capital gains exposure is often very large, due to the ongoing deductions for depreciation of the property’s cost basis that are taken along the way.

The limit this technique, Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first, created as part of the original rule under IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation recapture will still be taxed (at a maximum rate of 25%).

Example 2a. Harold has a property in 2009 that was purchased for $200,000 and is now worth $350,000. It was rented for a period of years (during which $29,000 of depreciation deductions were taken), and last year Harold moved into the property as a primary residence. The current cost basis is now $171,000 (after depreciation deductions), which means the total potential capital gain is $179,000. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion.

In addition to the limitation of Section 121 regarding depreciation recapture, as a part of the Housing Assistance Tax Act of 2008, Congress further limited the exclusion of capital gains for property that was converted from a rental to a primary residence. The new rules, enshrined in IRC Section 121(b)(4), stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence; any other time (since January 1st, 2009) that the property was not used as a primary residence is deemed “nonqualifying use”. Accordingly, to the extent gains are allocable to periods of nonqualifying use (gains are assumed to be pro-rata over the holding period), those gains are not eligible for the exclusion.

Example 2b. Continuing the earlier example, if Harold had actually rented out the property for four years (2009, 2010, 2011, and 2012) and then used it as a primary residence for two years (2013 and 2014) to qualify for the capital gains exclusion, and sell it next year (after meeting the 2-year use test), the total $150,000 of capital gains (above the original cost) must be allocated between these periods of qualifying and non-qualifying use. Since there are only 2 years of qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). As a result of these limitations, the remaining $100,000 of capital gains attributable to nonqualifying use will be subject to long-term capital gains tax rates (along with the $29,000 of depreciation recapture).

Example 2c. Assume instead that Harold had purchased the property not in 2009, but in 2000, and rented it for 13 years (from 2000 to 2012, inclusive) before moving into the property in early 2013 to live there for 2 years, with a plan to sell in 2015 and maximize the Section 121 capital gains exclusion. Because only nonqualifying use since 2009 counts under IRC Section 121(b)(4), Harold will be deemed to have 4 years of non-qualifying use (2009, 2010, 2011, and 2012), and 11 years of qualifying use (2000-2008 inclusive, and 2013-2014). As a result, 11/15ths of gains, or $110,000, would be qualifying gains eligible to be excluded (and since that’s less than the $250,000 maximum exclusion amount, it would all be excluded), while only 4/15ths of the gains, or $40,000, would be nonqualifying and subject to capital gains taxes. In addition, any depreciation recapture since 2000 would still be taxed as well.

Converting Rental Property Into A Primary Residence After A 1031 Exchange

Notably, an additional “anti-abuse” rule applies to rental property converted to a primary residence that was previously subject to a 1031 exchange – for instance, in a situation where an individual completes a 1031 exchange of a small apartment building into a single family home, rents the single family home for a period of time, then moves into the single family home as a primary residence, and ultimately sells it (trying to apply the primary residence capital gains exclusion to all gains cumulatively back to the original purchase, including gains that occurred during the time it was an apartment building!). To limit this, American Jobs Creation Act of 2004 (Section 840) introduced a new requirement (now IRC Section 121(d)) that stipulates the capital gains exclusion on a primary residence that was previously part of a 1031 exchange is only available if the property has been held for 5 years since the exchange.

Example 2d. Continuing the prior example, assume that Harold’s original ownership since 2000 was of an apartment building, and in early 2011 he had completed a 1031 exchange to a single family home, with the ultimate intention of moving into the property as a primary residence to claim the capital gains exclusion. Even if Harold moves into the property in early 2013 and lives there for 2 years, he will not be eligible for any capital gains exclusion until 2016 (five years after the 1031 exchange). At that time, he can complete the sale and be eligible for the exclusion. He will still have 4 years of nonqualifying use (2009 after the effective date, though the end of 2012 when the property was still a rental), but will now have 12 years of qualifying use (2000-2008 inclusive, and 2013-2016), which means 12/16ths of his gains will be eligible for the exclusion and 4/16ths will be deemed nonqualifying use capital gains and subject to taxes (in addition to any depreciation recapture).

Fortunately, while the rules do limit the exclusion of capital gains attributable to periods of nonqualifying use (after 2009) in the case of a rental property converted to a primary residence, the rules are more flexible in the other direction, where a primary residence is converted into a rental property. IRC section 121(b)(4)(C)(ii)(I) allows taxpayers to ignore any nonqualifying use that occurs after the last date the property was used as a primary residence, though the 2-of-5 ownership-and-use tests must still be satisfied.

Example 3. Donna has lived in her property as a primary residence since 2008. In 2012, she received a new job opportunity across the country, but decided she didn’t want to sell the property yet as home values were still recovering in her area, so she rented the property instead. Now, in 2014, as home prices have continued to appreciate, she wishes to sell the property. Even though there have been 2 years of otherwise-nonqualifying-use as a rental, Donna does not have to count nonqualifying use that occurred after she lived in the property as a primary residence. As a result, all gains will be treated as qualifying, and eligible for the capital gains exclusion (except to the extent of any depreciation recapture). Even though Donna does not still live in the house as a primary residence, she has still used it as a primary residence in at least 2 of the past 5 years (as she lived there in 2010 and 2011 before renting in 2012), so the Section 121 exclusion is available. However, it’s notable that if Donna waits until 2016 to sell, at that point there will be 4 years of rental use and only 1 year of use as a primary residence, so Donna will lose access to the Section 121 exclusion simply because she no longer meets the 2-of-5 ownership-and-use test.

In the above example, if Donna had chosen to subsequently exchange her converted rental property to a new one under IRC Section 1031, additional rules apply under IRC Section 2005-14 to properly allocate gains between Section 121 exclusion and Section 1031 deferral.

Planning Implications Of Section 121 Primary Residence Gain Exclusions

Arguably the Section 121 exclusion of capital gains on the sale of a primary residence is one of the most favorable tax preferences under the Internal Revenue Code, given both the sheer magnitude of the gains that can be excluded, and the fact that there is no limit to how many times it can be taken (beyond the limit of no more than once every 2 years).

Of course, from a practical perspective, many (most?) individuals and couples treat their home as a home, and not as an ongoing chain of serial real estate investments from which tax-free capital gains can be harvested as long as they live in it for at least 2 years first (which in reality is why Congress allows such favorable provisions in the first place). While a few clients might actually be inclined to move repeatedly from one property to the next – taking advantage of the capital gains exclusion every time gains approach the maximum exclusion amount – this will not likely be a popular strategy for most.

However, given that most clients will probably only have an opportunity to take advantage of these rules a couple of times throughout a lifetime, it becomes all the more important to properly plan in the first place to ensure the exclusion will be available. This may include having clear documentation to show exactly when the property was used as a primary residence (especially if it may not be the full 2-year period and the pro-rata partial exclusion may apply, or if there are periods of qualifying and nonqualifying use), and also planning around using the exclusion in the event of death or divorce of a spouse (in both situations, ownership and use of a deceased spouse or an ex-spouse can potentially be ‘tacked on’ to the subsequent owner to qualify for the exclusion). In the case of newly married couples, this may include additional coordination if either (or especially if both) previously owned a primary residence, and wish to sequence their sales to allow the maximal exclusion (for instance, one spouse sells one property for a $250,000 exclusion, both move into the other property for 2 years, and then the couple sells the second property for a $500,000 exclusion).

For clients that are more active real estate investors, there may be significant appeal to more proactively taking advantage of the primary residence exclusion rules, notwithstanding the limitations on nonqualifying use, especially in light of the fact that gain is always assumed to be allocated pro-rata across all the years, and not necessarily based on when gains actually occurred. This effectively creates an incentive for property that has rapidly appreciated during its rental period to be converted into a primary residence, even if the appreciation rate will slow.

Example 4. Donald purchased a rental property in early 2009 at the market bottom for $400,000, and it has appreciated in the 5 years since to $750,000. If Donald sells his current house, and moves into the rental property now to make it a new primary residence and sells it in 2 years for $775,000, the total gains above original cost will be $375,000. Since Donald will have 2/7 years of qualifying use, he will be eligible to exclude 2/7 * $375,000 = $107,143 of capital gains, even though the actual gains during his time living in the property were only $25,000. In addition, Donald will have been able to benefit from the capital gains exclusion on his prior home (sold 2 years ago), and the capital gains exclusion again on this rental-property-converted-to-primary-home, as long as the sales are at least 2 years apart. (Alternatively, if Donald had not sold his prior residence, he could have simply held it throughout, and then moved back into the original property and continued its use as a primary residence, though there would now be 2 intervening years of nonqualifying use for that property.)

Given that nonqualfiying use only counts for such use since 2009, real estate investors may find it most appealing to move into older rental real estate properties, that have a significant amount of gains that can be allocated prior to 2009 (where even though it was rental property, it doesn’t count as nonqualifying use). The qualifying/nonqualifying use rules will make the strategy less appealing for most real estate investors on a forward-looking basis, though planning opportunities remain in the aforementioned scenarios where rapid appreciation during nonqualifying use periods can be sheltered by subsequent qualifying use when there is slower growth (effectively shifting income from the less favorable time period to the more-tax-favored one).

In the case of properties that have been converted from a primary residence into rental real estate, the key planning issue is to recognize that there is a limited time window when a property can be rental real estate but still be eligible for the Section 121 exclusion – eventually, the property is rental real estate so long, the owner will no longer meet the 2-of-5 use-as-a-primary-residence test. For instance, in the earlier Example 3, Donna can only rent the property for up to 3 years after living there as a primary residence, before she can sell it and claim the Section 121 exclusion (or risk moving beyond the 2-of-5 years time window).

The bottom line, though, is simply this: for those who are more flexible about their primary residence living arrangements, and move more frequently (or are often forced to do so by job/life circumstances) there are significant tax planning opportunities available thanks to the Section 121 capital gains exclusion on a primary residence. For clients who are more active real estate investors, and have the flexibility to convert rental properties into primary residences, additional opportunities apply to navigate the nonqualifying use rules (and/or simply recognize that pre-2009 rental use won’t be counted against the owner as nonqualifying use in the first place!). However, because of the stringency of the rules – and the magnitude of the capital gains taxes that may be due if a mistake is made – it’s crucial to follow the rules appropriately to gain the maximum benefit (or any benefit at all!)!


  • JC

    To make things more complex, some people also built a 2nd living space (i.e., a guest house or a fully converted garage) and rented it out. Does it also impact the applicable exemption amount? I read something a while. Apparently, if the extra unit is attached to the main house, then the owner could disregard it. However, it will be a different case if the unit is a stand alone one sharing the same lot.

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  • Charlie Ambroselli

    Thanks Michael. As always, very helpful.

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  • MSA Properties

    Thank you for an excellent explanation. But what if a property started as a primary residence, then became a rental, then the owner moved back for 2 years to make it primary. For example, if a property was purchased in 1992 for $115,000 and the owner lived there until 1997. Then rented from 1997 through 2014. Then moved back for 2 years (2015, 2016). Then sold it for $415,000 in 2017. Would the $300,000 Capital Gain be excluded because the property was converted as a primary residence into rental real estate in 1997, even though it was rented from 1998 through 2014, and then moved back in to meet the 2 year rule?

    • http://www.kitces.com/ Michael Kitces

      MSA,
      If your example, there would be 6 nonqualifying years (2009, 2010, 2011, 2012, 2013, and 2014). All of those years of nonqualifying use would count. You can only exclude nonqualifying use BEFORE 2009 (when the rules didn’t apply yet), or nonqualifying use AFTER THE LAST DATE the property is used as a residence (and since the property is used as a residence in 2015 and 2016, you can’t ignore any of the prior nonqualifying use).

      Given that the property would be owned for approximately 25 years (from 1992 to 2017), and there are 6 years of nonqualifying use, then 6/25ths of the gain would be nonqualifying, and the other 19/25ths of the gain would be eligible for the $250,000/$500,000 capital gains exclusion.
      – Michael

      • RKD

        Michael Kitces,
        MSA said that it used this property as a primary residence from 1992-1997 and only then converted in into a rental unit. It seems that there is NO nonqualifying use since this property was FIRST used as a primary residence and only then converted to a rental. If MSA moved in to make it a primary residence in 2015-2015 in order to satisfy the 2-out-of-5 years as primary residence test then wouldn’t the entire gain upto the maximum limit $250,000/$500,000 be sheltered from long term capital gains tax?

    • RKD

      See my question to Michael below

  • jim h

    My wife and I purchased a home (home x) as our personal residence in 1977 for 39k. 1981 purchased another home as personal residence converting X to rental and has been rental since ’81. Now retired and will be moving back into X. After two years of occupancy will we be eligible for the exclusion of gain? Do the rules enacted in 2009 apply since this was originally purchased as personal residence? X is now worth about 400k. We have not used the personal residence sale exclusion at on any prior sale as subsequent homes were sold at a “loss” or no gain (short sale) Any thoughts, suggestions?

  • Edward

    I have a second home consider primary for 4 months (April, 2013), I will renting it out for 2 years, plan to live there for 2 years. Could I claim exclusion?

  • Dougie

    Michael,

    I just sold a lot I owned for 25 years. I had no depreciation taken, because it was a lot.
    The basis is $100,000, and the net sale proceeds were $415,000, for a $315,000 gain.

    I just 1031ed (is that a word) the $415,000 into a $475,000 rental house, adding $60,000 cash, which closed September 1 2014.

    I will rent the house for three years, and then my wife and I will move in for the two years remaining for the 5 year period and then sell the house. (As I understand it, I could move there for the last four of the five years to pick up two more qualifying years – is this correct? But I am not yet ready to move into it

    Since the lot was an investment property, but not a rental, for the 25 years, does this mean the entire time up to the 1031 is qualifying time?

    Assuming we sold the house for $650,000 in September 2019, what would our capital gains tax look like?

    A few questions, I know, but your input would be helpful to us and those like us.

    Doug

  • Dave

    Hello and thank you for your very helpful responses at this site!

    I have a question regarding the Housing Assistance Tax Act of 2008 and how it may impact my Capital Gains exclusion upon sale of my property.

    My wife and I owned and lived in our home from 2003 to 2013 as our primary residence. In November 2013, I moved for work and we converted our home to a rental. If I continue to rent the home and then sell prior to November 2016, will we still qualify for $500k in capital gains exclusion (because we lived in the home 2 of the prior 5 years preceding the date of sale), or will we have to pay capital gains on a % of our gains because of the Housing Assistance Tax Act of 2008 (since the property was used as a rental subsequent to Jan 2009)?

    Thank you!

    • http://www.kitces.com/ Michael Kitces

      Dave,
      Per the article and discussion of IRC section 121(b)(4)(C)(ii)(I), when it’s a primary residence first and converted to rental property second, nonqualifying use AFTER it was a primary residence is not considered as long as the property is otherwise still sold in time for the 2-out-of-5-years test.

      So yes, as long as you sell the property by November of 2013, all of the gain will be qualifying use, and all of the gain will be eligible for the $500k capital gains exclusion. (Though any depreciation will still be subject to recapture gain.)
      – Michael

  • HomeSeller

    Thank you Michael. This is the best article on this subject I have come across to date.

  • Rose

    Thanks for the article. Very informative. my question is the following. I one of my properties for 2 years. Then renovated it and moved into it this year. I understand I can no longer take the depreciation deduction for the value of the house. Does this apply to everything else? I was amortizing closing costs and points. If i can’t take those deductions in full, would i take them for the 2 months the house was rented in 2014? Final question, I have a losses from 2013 i was not able to fully deduct due to passive loss rule. I was going to carry that into 2014. Can I take that loss or because the house is no longer a rental I can’t? Thanks in advance for your help!

  • Raymond

    My wife and I own a Duplex that we built in 1993. The property was built for $260,000. One unit was rented throughout, the other never was. 7 years as our primary residence and the balance as a home for our daughter, no rent was ever charged. I have taken 1/2 of the total cost and took depreciation for all years but no depreciation on the other unit. We are considering establishing the unit that has never been rented as our primary residence. I assume that at sale our cost basis for that unit will be $130,000 and subject to the max $500,000 tax free. Is the rental unit to be treated as simply a Capital Gains event after depreciation recapture

  • Rich

    I bought my house in 2009 for $1.3M and used it as a primary residence through 2014. It is worth about $1.7M now but I would like to rent it for 2 years ($10K a month) and then sell it.(I hope of $2M in two years.)
    What are the benefits of selling now or waiting the two years?

  • Lisa

    Property was purchased in 1973. It was rented for about 27 years.Then it was exchanged for 2 properties in 2009. One was rented for 4 years and then became a vacation home. One is still rented. Now, we are thinking of making the vacation home a primary residence for 3 years then selling it. In this situation, what kind of capital gains taxes would be due, assuming sales price is $325,000 with no basis. And what about if it converts from 4 years rental, to say 3 years primary, to one year rental. Will that lessen capital gains due?

  • Joe

    I personally own a property that was a business rental property. I moved into the property and have used the second floor as my principal residence for the last 2 years. There is no separate entrance for the upstairs. I believe I do not have to allocate any of the gain and will only have to pay tax on the recapture. Can I get your take on this? I am reading Publication 523 and it states:
    Property Used Partly for Business or Rental:
    If you use property partly as a home and partly for business or to produce rental income, the treatment of any gain on the sale depends partly on whether the business or rental part of the property is part of your home or separate from it.
    Part of Home Used for Business or Rental:
    If the part of your property used for business or to produce rental income is within your home, such as a room used as a home office for a business, you do not need to allocate gain on the sale of the property between the business part of the property and the part used as a home. In addition, you do not need to report the sale of the business or rental part on Form 4797. This is true whether or not you were entitled to claim any depreciation. However, you cannot exclude the part of any gain equal to any depreciation allowed or allowable after May 6, 1997. See Depreciation after May 6, 1997, earlier.

  • akash

    On your June 4 2014 newsletter , example 2d. Does this apply to an LLC. If an LLC owns the property and a 99% owner of the LLC converts the property into a primary residence. Will Example 2d still apply.

  • Mike K.

    Very informative article; wish I had seen this back in 2009. Here’s my question: I am looking to sell my principal residence this year and am also considering doing a 1031 exchange on an investment property in the same time period. I am aware of the 2 year rule for the exclusion of gains on a principal residence. Will selling both my investment property (thru a 1031 exchange) and my principal residence in the same year have any impact on my qualification for the exclusion of gains on my principal residence? Are there any other factors regarding taxation that I should be aware of if I do both sales within the same year?

  • Steve K

    I am about to purchase an investment property which will be converted to our primary residence in 5 – 10 years.
    The question I have is how depreciation will impact our taxes 5 – 10 years from now when we move in. Also, is there some particular way we should be filing taxes for the next 5 – 10 years to minimize the tax impact?

  • Jules

    Wonderful article, thanks! I’m working hard with my limited knowledge to understand it to apply it to my situation: Purchased duplex @ 65K in 1996 and lived in half then moved and rented both units until sold @ 175K via 1031 exchange completed Aug 2002 for SFH @ 180K. SFH has been rented 100% of the time since then and is assessed at $236K. I’m considering the financial pros and cons of doing another 1031 exchange vs. moving in myself June 2015 and selling June 2017 @ maybe 275-300K with some upgrades (kitchen/baths) and would love your feedback!

  • Alex

    When you say non-qualifying use , do you mean any use of the property other than primary residence, the confusion is regarding repeated mention of rental property. Rental Property is treated much differently according to the IRS, then say a mortgage interest deduction for two homes that are not rental properties in other words personal use.

    What happens if one spouse has the homes as a primary residence and other doesn’t. Although you would have to file taxes jointly to qualify, there is no requirement for both spouses to live in the same home for the last 2 out of 5 years although you will still have to wait 2 years before again taking the exclusion, would this be advised for properties of personal use.

    • http://www.kitces.com/ Michael Kitces

      Alex,

      Per the article (and under the tax code), non-qualifying use is defined as any time (since January 1st, 2009) that the property was NOT used as a primary residence. It doesn’t matter what you did with it; it just matters that it was NOT used as a PRIMARY residence.

      If only one spouse meets the “use” test as a primary residence, the couple will be limited to a $250,000 exclusion. In order to qualify for the full $500,000 exclusion, BOTH spouses must meet the use test (though notably, EITHER spouse can meet the ownership test, so the property doesn’t have to be jointly owned).
      – Michael

  • Alex

    Also, are the rules different for instance, Sally and Bill has Home A and Home B, Home A is either Sally’s or Bill’s PR (primary residence), they both file a joint tax return.

    Let’s suppose they bought Home B and owned it for several years as a second home in a vacation area or say Florida, after several years of owning the home as a non-qualified residence basically non-pr

    (I won’t get into the details of saying its a rental vs. a second home with a mortgage since there are depreciation and other rules but feel free to elaborate if it matters).

    So they decide as many folks do to sell Home A and take the exclusion. They move into Home B and now that property values are on the rise they won’t to downsize and move to a smaller property. However, they realize they don’t be able to take the full capital gains exclusion as it would be pro-rated between non-qualified vs. qualified PR use.

    Suppose however they go ahead and buy a condo, which I will list as Home C 2 years later, they then decided to retain Home B (either rent it or use it as second home on occassion and deduct mortgage interests).

    Family and Friends come over to visit often and eventually their mother-in-law decides to move in with them, since House C, a condo, is small, they move back into Home B and its the PR. The mother-in-law goes into a nursing home two years later (Feel free to insert what years matter), They rent the Home B or leave it vacant again for 2 years, and go back the condo, Home C which was being rented or left vacant while they were in Home B.

    My understanding is a period of non-pr or non qualified use is pro-rated but what happens in this situation, my understanding is that non-pr cannot be followed by PR to claim the non-pro-rated exclusion, but that PR can follow non-PR, I am not sure what happens if things alternate as how they moved into Condo C and then back again. Can they claim the full non-prorated capital gains exclusion of $500,000. My previous question of course indicated that what happens if one spouse has one PR and the other another PR which is not the case here.

    • http://www.kitces.com/ Michael Kitces

      Alex,
      You can still have nonqualifying use (“non-PR” in your terms) occur after qualifying use as a residence. The tax code allows you to exclude the LAST segment of non-qualifying use after the LAST use as a primary residence (assuming you’re still otherwise within the 2-out-of-5 requirement to be eligible for the capital gains exclusion at all).

      So if you alternative 3, or 5, or 7, or however many instances of non-qualifying and qualifying use, the LAST non-qualifying after the LAST qualifying segment doesn’t have to be part of the calculation of non-qualifying use. All the OTHER non-qualifying use periods will still be counted as non-qualifying use when calculating how much in capital gains can be excluded.
      – Michael

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    I purchased a condo in 2007. I rented the condo for 6 years. I have now lived in the condo for a little over two years as my personal residence. Is there any other way to meet the five-year requirement to avoid capital games if I don’t continue to live in this house. For instance, is it possible to do another exchange and continue to defer capital games as I’m living in the second property as my personal residence? In other words can I combine the amount of time spent as a rental and the amount time spent as a personal property amongst two properties the current property and a new property?

  • Billy Rawle

    Alex,
    We purchased a SFR in 1990, lived in it as our primary residence until April 2005. Rented it from April, 2005 through 2015 and are going to make it our primary residence starting in 2016. We plan on living their for 2 or 3 years and then selling it. Assuming the laws do not change would the qualifying years be 1990 – 2009 and 2016 – 2018 and the non-qualifying years be 2009 to 2015?

  • Billy Rawle

    Michael,
    If we convert a rental property into our primary residence and two years later sale the home. When do we have to recapture the depreciation? In the year we convert to a primary residence or when we sell the home?

    • http://www.kitces.com/ Michael Kitces

      Depreciation recapture occurs at the time of sale.

      When you convert into a primary residence, you’ll simply stop claiming ADDITIONAL depreciation at that point.
      – Michael

      • Billy Rawle

        Thank you, Michael

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Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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