IRS Says “Not So Fast” On 2 out of 5 Primary Residence Rule


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One of the most misunderstood parts of real estate tax is the capital gains exclusion for primary residences that you have lived in for 2 out of the previous 5 years. It used to be just that simple. If you lived in a property 2 out of the past 5 years, you got to take either $250,000 of capital gains tax free (single) or $500,000 of capital gains tax free (married, filing jointly).

Quietly, the IRS has been changing the rules. Or maybe not so quietly, it’s just that there has been so much other news that than it’s been easy to have missed some of the changes.

There are three major changes. In today’s blog, I’m going to talk about what happens if you move into your former rental property.

First of all, you do not get to move into a former rental property and automatically get all the gains tax free as long as you’re under the capital gains exclusion amount.

The first change, which I think is a little better known is that you have to pay tax on the recaptured accumulated depreciation. So even if you normally would have had capital gains exclusion to cover all the gain, you still have to pay tax on the previous depreciation that you have taken on the property.

The second change has to do with the fact that it was rented before. You have to calculate the total gain first and then determine how much is applicable to the period that it was rented out past 2009 and how much was applicable to the years you lived in it.

Let’s say that you owned a property for 6 years. For the first 4 years you rented the property out. You then lived in the home as your primary residence for the next 2 years. You had a total of $150,000 of capital gains over the 6 year period.

However, you lived in the home for 2 out of 6 years since 2009, so only 1/3 (2 divided by 6) of the capital gains will be considered qualifying use. That means you have a capital gains exclusion of $50,000 (1/3 of $150,000). Of course, there is depreciation which also must be recaptured.

And, of course, there are some strategies you can use to maximize the capital gains exclusion. That’s just one little aspect of tax that has changed. Make sure you pick up your copy of “FIRST LOOK! Taxmageddon 2018” when it releases with a soft opening here on USTaxAid.com.



2 Comments

  1. Diane Kennedy says:

    Great question, Ken. It brings up 3 different important law changes that people often forget and is too much to cover in a response here.

    I’m going to write a blog about it to post sometime from 1/22/21 – 1/24/21.

  2. Ken says:

    My wife and I
    1. Bought our only house in 1987 and lived there until 1994 and rented it until 2013.
    2. Sold the first house and bought another house through a 1031 exchange in 2013.
    3. Plan to sell it and buy a similar house through a 1031 exchange again in Q1 this year.
    4. Plan to rent it for two years and then live there many years as our primary residence but live there at least three years.

    Can we (joint filing) get the maximum exclusion if we sell the house in the step (3) above after five years?

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