Capital gain tax 5 years rule question

10 Replies

Hi everyone, 

I would appreciate if someone can answer this question for me.

I bought a house in Houston in March of 2012. We lived in it for two years and been renting it since.

I am selling my house next month which will make it 5 years and 8 months.

Can I qualify for exemption from capital gain tax?
Thanks in advance

@Rachid B.

there are some exceptions to the 2 out of 5 year rule that allows you to get a partial exclusion.

Work-related move

Health-related move

Unforeseeable events such as family death, multiple baby births, etc that caused you to move?

See publication page 5 for more details on exceptions.

Does any of the above apply?

Updated over 1 year ago

Please disregard my post. Dave is correct - my exception does not apply here.

Sorry, but the answer is no.  You have maintained your former principal residence as an investment rental for more than three years after vacating.  Your property is now an investment property and its sale is a taxable event.  In addition to the capital gains tax on your sale profit, you will also have a tax on the unrecaptured depreciation you took (or should have taken) while the property was in service as a rental.

The potential exceptions @Basit Siddiqi mentions only apply to homeowners who have to move before they are able to meet the two year tests.  You met them but just did not sell the property during the three year capital gain exclusion window that started the date you moved out.

There is one exception that may be available to you.  For military members ordered to depoy overseas, the 2 of prior 5 year rule is extended to 2 of prior10.  

Thank you Basit and Dave. I appreciate your response.  disappointed :-(

What is the tax rate by the way? is it fixed or it varies based on our household income?


@Rachid B.

The current long term capital gains tax rate is either 0%, 15%, or 20% depending upon your marginal income tax bracket.  Not clear yet how tax reform legislation will affect the capital gains tax rates.

@Rachid B.

I respectfully disagree with @Dave Toelkes on this one.

The exceptions initially listed by @Basit Siddiqi are part of Regs. 1.121-3 which do not restrict the limited exclusion to the "before 2-yr" scenarios only, as far as I can see. The limited exclusion is potentially available whenever any of the three tests fails, regardless of timing. Please correct me if I'm missing something in these Regulations.

While it would be hard to meet the legal criteria in your case, it nevertheless seems possible under the right circumstances. For example, if you have to sell this property because a change of employment makes it impossible to continue leasing this property. It does sound shaky, and it does seem to violate the spirit of the 2-out-of-5 rule, but I don't see where such scenarios are specifically prohibited by the Regulations.

Worth a try, in my opinion. By trying I mean discussing with a real estate accountant, examining your specific circumstances.

@Michael Plaks

Reg 1.121-3b(6) limits application of the limited exclusion to circumstances that required sale or exchange of the property while the property was in use as the taxpayer's principal residence.  

Since the property in question had been used as a rental for more than three years at the time of sale, it seems to me that the limited exclusion clause is not applicable for this scenario.

@Michael Plaks , @Dave Toelkes is right.  The three tests limit the look back to a 5 year period prior to the sale of the property.  It must have been the residence of the owner/taxpayer for a cumulative, not consecutive, 24 months out of the 60 months prior to sale.  

What will really bite is if the current reform proposal is approved that will increase to a 5 year residency period out of the 8 years immediately prior to sale.

Colleagues, these are you opinions and interpretations. Let's talk the law, shall we?

@Dave Toelkes noticed ONLY the end of the phrase in Reg 1.121-3b(6) and decided that it "limits..." 

What about the beginning of this same sentence, that reads: "Factors that may be relevant in determining the taxpayer's primary reason for the sale or exchange include (but are not limited to) the extent to which..."

Did you notice "may be relevant" wording that I bolded? This is merely a list of suggested factors - which is NOT a prohibitive limitation. I see room for interpretation.

@Linda Weygant

@Dave Foster - please see above, I could not tag you in the prior post for some reason

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