2 out of the last 5 rule?

Question

Hey all,

I am considering on selling my condo next year.  At the time I sell it, I will have lived there 1 out of the last 5 years and renting out since moving out.

One of my CPAs said I can still be exempt up to $125k and not the $250k.  I thought it was all or nothing deal.  Meaning, if you don’t live there 2 out of the last 5 years, you’re exempt nothing.  If you hit that mark, you get the full exemption.

Anyone have experience with this, or can shed some light?

Thank you much!

Dave Foster · Answer

@Kenny Smith, The reason is that you are actually converting an investment property to your primary residence (even though it also used to be your primary residence originally).  This conversion eliminates full use of the 121 primary residence exclusion.  You will only get the exemption prorated for the years in which you lived in it.  So if you lived in it for 1 year and rented it for 3 years and then moved back in and lived in it for 1 year you would have lived in it for 2 out of the previous 5.  But you had also converted it from investment to rental.  So you would get 2/5ths of the profit tax free.  And you would have to recapture depreciation.  Still not a bad deal.  But not moving back in and doing a 1031 defers all tax and depreciation.  Just depends on your your needs and wants.

Matt Devincenzo · Answer

It sounds like he may be applying a pro-ration to the exclusion, which there is a provision for. But that provision is for things like a job transfer etc that were out of your control...I also think they may only apply if you didn't achieve the 2 years, not if you did reach it and then 'lost' the eligibilty.

That said I'm also not a CPA/EA so hopefully one of them can help clear this up.

Bill B. · Answer

Of course it doesn’t help to say you should have sold 6 months ago tax free. But…

if you move back in for 2 years you’d save 50% (4 occupied years out of 8 owned years.)

You could do a 1031 exchange in to a different property.

You could pay 15% capital gains tax on the profit plus 25% depreciation recapture on approximately 15% of the building’s value (4/27.5ths) if that amount isn’t soul crushing. (Only net sales amount, commissions and such come off first.)

You could keep renting it out since you missed the deadline.

Bill B. · Answer

I’m. 99% sure 23.5 months doesn’t qualify for any tax savings, but I am not a CPA. Which means I hope I’m wrong or that’s a bad CPA.

Ps. Have you owned it exactly 5 years? (Was it your primary for only 1 year and then a rental for 4? Or was a primary for longer? Again, I don’t think it matter but more info for an expert who may weigh in later. I do know you only get a proration if it was a rental, so moving back in now for 2 years would only save you 40% (3 out of 7 years.)