The Two Out of Five-Year Rule For Primary Residences Doesn’t Work In This Case | USTaxAid

Diane Kennedy's Blog

The Two Out of Five-Year Rule For Primary Residences Doesn’t Work In This Case

Written by Diane Kennedy, CPA on February 6, 2022

You may have heard of the 2 out of 5-year capital gain exclusion. If you live in your primary residence for 2 of the previous 5 years, you can take an exclusion of up to $250,000 (single) or $500,000 (married filing jointly) when selling for a gain.

But not so fast.

There is a “gotcha.”

If you move into a rental property, you don’t get to exclude all of your gain. Instead, you need to do an allocation between the time your property was a rental and when you lived in it as a residence.

Also, if you had a rental, you may have also had depreciation expense. You need to recapture and pay tax on the depreciation no matter what.

If your primary residence started out as a rental, you’ll have to pay some tax when you sell at a gain no matter how long you live in it.

This is another one of those issues where you need to make sure you have accurate and up-to-date information when you search on the Internet.

Here is more information on this subject:

IRS Says Not So Fast on 2 Out of 5 Primary Residence Rule

Tax law is rapidly changing. What was a great strategy a few years ago might not work at all anymore. In fact, some of the best tax strategies of “old” could end up costing you a lot more in taxes. 

One Comment

  1. Cam Pesh says:

    Diane, thank you, thank you, thank you. The generous sharing of your knowledge is much appreciated. I’m a long time follower and fan, and once again you’ve enlightened me.
    More by circumstance than design, my husband and I have a small rental house on Long Island that’s appreciated greatly recently. I had planned on making it a primary residence, living there for two years, selling it and thereby bypassing paying capital gains on the sale. Then all we’d have to pay was the recapture tax on depreciation taken from 2009, which is the actual year we converted our then primary residence into a rental.
    You’ve here made it clear that we’d only be entitled to claim the exclusion on the amount that had appreciated during the time we lived in it, not the appreciation gained during the rented out years. Nowhere else have I read this.
    So it’s back to the drawing board to decide how to best proceed to minimize capital gains taxes.
    Once again, dear Diane, thank you for your generosity. Stay well, fondly Camille

Leave a Comment

SIGN UP TO DIANE’S FREE NEWSLETTER!

  • Three weekly emails with free tax updates
  • Exclusive deals on products and services
  • FREE Video: How to Write Off Practically Anything