Avoid capital gains on primary/rental property

[Loren Whitney]

I'm hoping that someone can help me figure out a tax question related to capital gains. This is really a two questions. I've been reading about the exemption from capital gains if you occupy a primary residence for 2 of the last 5 years. I read that the time does not have to be consecutive, right? If I rent a property for 2-3 years but still meet the 2 year rule, what happens to the depreciation I claim during the rental years? Does my cost basis just adjust or do I have to pay taxes on that amount separately upon sale of the property? Just trying to wrap my head around this concept. We're actually six months away from the 2-year mark on our current primary but thinking about turning it into a rental. Just trying to strategize. Thanks!

[Nathaniel Busch]

Originally posted by @Loren Whitney:

I'm hoping that someone can help me figure out a tax question related to capital gains. This is really a two questions.

I've been reading about the exemption from capital gains if you occupy a primary residence for 2 of the last 5 years. I read that the time does not have to be consecutive, right?

If I rent a property for 2-3 years but still meet the 2 year rule, what happens to the depreciation I claim during the rental years? Does my cost basis just adjust or do I have to pay taxes on that amount separately upon sale of the property?

Just trying to wrap my head around this concept. We're actually six months away from the 2-year mark on our current primary but thinking about turning it into a rental. Just trying to strategize. Thanks!

Loren, 

Be very careful when toggling a property back and forth from rental to personal. 

When depreciating as a rental, be sure to use the lesser of Fair Market Value or your cost basis. Furthermore, when you sell the property any and all depreciation taken as a rental property must be recaptured as ordinary income regardless of whether you move back into the property or not. 

Any gain on the property would be excluded as taxable, just as long as you can show you used the property as a primary residence for any 2 years of the past 5. There is no rule requiring consecutive year ownership. 

Nathaniel Busch, CPA