Q. Am I able to claim capital gains exclusion based on 2 out of 5 years [with 10 year extension]?
A. Yes. Yes, your logic is correct.
As SweetieJean said, you disregard the mortgage payoff. It does not enter into the capital gain calculation. Your gain is sales price less cost basis (what you paid for it + any improvements) less expenses of sale.
Q. How would I claim Capital Gains Exclusion?
A. The TurboTax interview handles this. The sale can be entered in the rental section. Alternatively, you can enter it as a home sale (my preference).
In the rental section show that you ceased renting the property. Then enter the sale at Less Common Income / Sale of Home. The interview should ask about your military time exception. When asked if you had a period of non-qualified use (rental), answer NO. In TT, at the page where it asks if you had any other use of the home it says: "Note: if you used your home for reasons other than primary residence, after it was no longer your primary residence, select 'no'''. Any portion of the 5-year period (+10 year extension) ending on the date of the sale or exchange after the last date you (or your spouse) use the property as a main home is not considered non-qualified use.
Follow the interview carefully.
