121 Exclusion - 2 out of 5 year question

6 Replies

Hi All-

I have a question about 121 exclusion rule. I understand I must own and live in my property for at least 2 out of the 5 years. My friend and I bought a house together as in tenants-in-common ownership in 2011. We have owned and lived in it for the first two years then we have decided to bring in 4 tenants to live with us in the 3rd year while collecting their monthly rents. We intend to keep them for another year (4th year). 

So, now the question is, how does this impact us with the 121 exclusion rule? I thought that we would qualify for the full capital gain exclusion of $250k at maximum each for me and my friend since we have already owned and lived in it for at least two years. However, my friend told me that we would not be eligible for the full capital gain exclusion because we are renting to 4 tenants in the 3rd year. Is this true? 

Let's say we have generated a total of $240k capital gain on the property. It is being split by two of us so that's $120k capital gain each we could claim for capital gain exclusion. However, my friend mentioned that since we are renting to tenants in the 3rd year and will again in 4th year, then our individual capital gain exclusion will not be at full $120k each and will be reduced because of that, say at end of 4th year.

Can anyone please help answer this question? I'd appreciate it!

Thanks,
Arthur

The rule is, you must live in it for at least two years, And 3 of the last five years.  I do not know how renting out a portion, while still living there affects this.

Perhaps @Steven Hamilton II  can help out.

Originally posted by @Wayne Brooks :

The rule is, you must live in it for at least two years, And 3 of the last five years.  I do not know how renting out a portion, while still living there affects this.

Perhaps @Steven Hamilton II  can help out.

 Thanks Wayne. I'll wait and see if Steven can chime in.

Account Closed  That is tricky and not sure how the IRS will look at it. If audited you will have to pass the sniff test. Did you have the utilities in your name? Hopefully you had electric, gas & water in your name at least 2 out of 5 years or you likely won't qualify. They will ask for copies of bills and or cancelled checks for proof at an audit.

You collected rent, did you claim it on your taxes, did your tenants take the renter deduction?

Just go ahead and claim the full exclusion the IRS will let you know if you owe them any money ( :

Here is a link to the IRS publication. You'll see scattered examples and several of them deal with what you're talking about. 

I'd have to go through and look at the specific examples to make sure but I believe your friend is at least partially right. 

Account Closed 

For my response, I am assuming that you and your partner have a residential dwelling structure that is not divided into separate rental and residential units. For example, let's say you have a four or five bedroom house and are renting out the bedrooms.  All occupants share a common entrance and exit as well as common living areas and kitchen. 

If this is the case, then because you both had already met the section 121 ownership and use tests in your first two years of ownership before you converted a portion of your house to rental use, you and your partner still have the full section 121 exclusion if you consummate a sale anytime before the end of the fifth year of ownership.  

If my assumption is wrong, then a different response is in order

Sorry, had a brain fart, it is 2 of the last 5.  I was thinking of the "3 year max" if you later convert to a rental, to still get it.

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