2/5 year rule for primary converted to rental

Rental Property Investor · Seattle, WA · Member since 2014 · 1k+ posts · 1k+ votes

As I understand it, if you live in the house for 2 years out of the last five before you sold, you get to avoid capital gains tax, so long as you bought as a primary residence, but the IRS doesn't care if it's the first two years or the last two years, so long as it was purchased as primary residence and not an investment property initially.

So what happens if you lived in the property the first 2 years, then rented it for 4, and move back into it for 2. Would you pay capital gains tax on the pro-rated portion or be exempt from capital gains (other than depreciation recapture)? Source please...

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Professional · Bothell, WA · Member since 2016 · 89 posts · 17 votes
9y
Rule is 2 of the last 5 years. IRS Pub 523.
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Jack B. If you meet the requirement of having lived in the property for 2 out of the previous 5 years then you would be able to apply sec 121 to your sale but there are two additional restrictions.
1. You will have to recapture all depreciation.
2. Because this is technically a rental turned into a primary I believe that you may only prorate the gain between years of qualifying (primary residence) use and non qualifying use (use as a rental).
So in your example you would have owned it for a total of 8 years of those 8 4 were primary residence and 4 were rental so you could exempt 50% of the gain tax free. If you wanted to shelter the tax on the remaining you could also do a 1031 exchange with the remaining.
Or make sure you move out the fist time and only rent it long enough so you can claim it as a primary turned into rental and that you have lived in for 2 out of the previous 5. In that case you would get the full exclusion and only have to recapture depreciation.
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Jack B.
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Rental Property Investor · Seattle, WA · Member since 2014 · 1k+ posts · 1k+ votes
9y
Originally posted by @Dave Foster:

@Jack B. If you meet the requirement of having lived in the property for 2 out of the previous 5 years then you would be able to apply sec 121 to your sale but there are two additional restrictions.
1. You will have to recapture all depreciation.
2. Because this is technically a rental turned into a primary I believe that you may only prorate the gain between years of qualifying (primary residence) use and non qualifying use (use as a rental).
So in your example you would have owned it for a total of 8 years of those 8 4 were primary residence and 4 were rental so you could exempt 50% of the gain tax free. If you wanted to shelter the tax on the remaining you could also do a 1031 exchange with the remaining.
Or make sure you move out the fist time and only rent it long enough so you can claim it as a primary turned into rental and that you have lived in for 2 out of the previous 5. In that case you would get the full exclusion and only have to recapture depreciation.
So despite living in it as a primary for 2+ years then renting out for 3+ years, if I move back into it for say, 5 years, I'd still owe capital gains tax on top of the depreciation, at least for a pro-rated portion of non-qualifying use?
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Dave FosterBusiness Member
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
9y
@Jack B., You're probably going to have to get a ruling on this - Or an okey dokey from your accountant at the least. Because it's not necessarily black and white.
What is clear that if you simply sell after living in it for 2 out of the previous 5 you can exempt up to $500K tax free.
It is also crystal clear that if you move out from you primary residence, convert it to a rental and still sell it when the 5 year look back applies that you can take your primary exemption and pay only depreciation.
It is also spelled out in statute that if you convert a rental to your primary residence you must prorate between qualified and non-qualified use.
Your scenario is a primary that you converted to a rental and then later after the 5 year look back no longer applied you took a rental and converted it into a primary. My guess is you have to pro-rate. But an agreeable accountant may be the key to a different answer.
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