The 7 years is non-qualified. If you sell in 2024 (owned for 15 years, 7 years non-qualified) that means that 7/15th of the gain is taxable. If your gain is $200K, then $93,000 is taxable, and the remaining $107K can be applied to your 250K personal exclusion. You will also have to pay depreciation recapture on the depreciation you claimed or could have claimed while the home was a rental.
The worksheets in publication 523 will walk you through the calculation, but they don't do a good job of explaining why the worksheets calculations work the way they do. You have to go back to about 2013 to find a version of pub 523 that tries to explain non-qualified use. (The term isn't even used in the current version.)
I will try to explain briefly.
Congress does not want landlords to get a full exclusion just by moving back into their home at the last minute. If you move out of your personal residence, rent briefly (up to 3 years), and then sell, the rental period is qualified. But if you move back in as your personal residence again the rental period becomes non-qualified. Here's an example of how the math would work in your case.
- Purchased for 200K
- Rented for 7 years, so you took or should have taken deprecation of about $45K. Your adjusted cost basis is reduced to $155K.
- Currently have lived there at least 2 years so qualify for the exclusion.
- You have made $20K of improvements which increase your cost basis to $175K.
- Sell for $400K.
- 7/15th of the gain is non-qualified and 8/15th is qualified.
- Your capital gain is $225K, because it is calculated from the adjusted cost basis after depreciation and improvements.
- First, you pay depreciation recapture on the 45K of depreciation. Depreciation recapture is taxed as ordinary income (your normal tax bracket) with a cap of 25%.
- The remaining long-term capital gain is $180K. Because 7/15th is not qualified, it is subject to long term capital gains tax ($84K). The 8/15th that is qualified ($96K) is eligible for the personal exclusion. Since the gain is less than the exclusion limit, that portion of the gain is excluded. You end up paying recapture tax on the depreciation and long term capital gains tax on 7/15th of the other gain.
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