Capital gains and rentals

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I'm asking this for a friend. They own a home and lived in it for two years and one month. They have moved and have been renting out the home now for the past three years. They are considering selling the home and when they started researching capital gains, realized that they would indeed paying them as the home has been a rental longer than it was a primary residence. She was initially under the impression that as long as the home was a primary residence for at least two years before becoming a rental this would not be the case. Apparently the laws on this changed in 2009? Does anyone know about this or have advice to offer?

If they have lived in the property for two of the five years before the sale, they have an exemption for up to $500K in capital gains.  If they have been renting it for three years or more, even one day more, as of the day of the sale then this exemption does not apply.  This has been the law for quite some time.  There was talk of changing this in the recent tax law changes, but that did not happen.  Length of time they lived there vs. length of time rented is not the criteria.  The criteria the two of five years.  Of the five years ending on the date of the sale, they must have lived in the house at least two years.  

They could look at doing a 1031 exchange into a new rental property to defer capital gains.  But if they are going to sell and keep the money, and have been renting for more than three years on the date of the sale, they will pay a combination of capital gains taxes and the tax on unrecaptured depreciation for the depreciation taken (or allowed, if greater) for the period they have been renting it.

I’m not a tax expert, but if they can get out of the property with zero tax...by all means do it. If they can’t, then I’d definitely consider a 1031 exchange to other investment property. If they don’t want to manage property, then they might look into some kind of managed property or check out a DST (depending on qualification). Good problems to have :)