2 out of 5 years rule

[dhold]

Purchased home 9/2012 and lived there as full-time personal residence until 3/2016. 

Then rented the property until 6/2023, when we will move back in as full-time personal residence. During the rental period we did not deduct any depreciation expense.

Question, if we use the home as full-time personal residence for the next two years and thereafter sell it, do we get the full capital gain exclusion?

[Mike9241]

despite the fact you did not depreciate it during the rental period, the tax laws require you to recapture the depreciation you should have taken as section 1250 gain when you sell. any gain attributable to 1250 gain is not eligible for the exclusion.   the way the computation of the exclusion works the way it works is first the gain is computed. From that, the depreciation you should have taken is subtracted. the lesser of the remaining gain or the home sale exclusion amount is exempt with any remaining gain eligible for long-term capital gain treatment.  consult a pro about correcting the depreciation error. it seems there are multiple choices. amend 2022, fix it on the 2023 return. or wait until you sell.   form 3115 is used to correct the depreciation error if you want to do it yourself. if you wait 2 years from the date last rented the full exclusion would be available if the gain is large enough after the depreciation recapture. 

[Hal_Al · Accepted solution]

Q.  Question, if we use the home as full-time personal residence for the next two years and thereafter sell it, do we get the full capital gain exclusion?

A. No. 

The gain will be prorated between the residence time and the rental ( "non qualified use") time. Deprecation  must still be recaptured, even in a  home sale exclusion situation. The recaptured depreciation is not included as a part of the exclusion calculation.

See sample calculation at:

https://ttlc.intuit.com/questions/4472518-we-moved-into-our-rental-property-and-now-less-than-two-ye...

[Carl]

During the rental period we did not deduct any depreciation expense.

Doesn't matter. When you sell the property you are required to recapture and pay tax on the higher of depreciation taken, or the depreciation you "should" have taken.  Recaptured depreciation is "not" exempt from being taxed under the "2 of last 5" rule. You will pay taxes on that depreciation, no matter what.

Question, if we use the home as full-time personal residence for the next two years and thereafter sell it, do we get the full capital gain exclusion?

No. Since the owner (you) will be the last occupant to vacate the property prior to the sale, the rental period before you moved out is non-qualified use. Your tax exempt portion of your gain will be pro-rated accordingly.

[Opus 17 · Accepted solution]

You are in a situation where you have "non-qualified use."  This is not well explained in the IRS publications but it is included in worksheet 2 of publication 523.  https://www.irs.gov/forms-pubs/about-publication-523

Also, you must recapture the depreciation you could have taken, even if you didn't.  You may want to see an accountant.  There may be a way to correct some of that depreciation and get a tax break for it now.  

To try and make this short, you can't convert a taxable gain on a rental into an exclusion by moving back into the home.  The in between period is non-qualified use.  In your case, suppose you move back in 6/23 and sell in 6/25.  You will be allowed to use the 5 year rule, but you have to account for the period of non-qualified use.  At that point, you would have 3.5 years of qualified use from 2012-2016 and 2 years of qualified use from 2023-2025, and 7.25 years of non-qualified use.  Of the total 12.75 years of ownership, 5.5 years, or 43%, is qualified.  Suppose your gain is $600,000, and $50,000 is attributable to depreciation you could have taken.   You pay ordinary income tax on the $50,000 depreciation recapture with a maximum of 25%.   Then, you pay long term capital gains tax on the non-qualified gain (57% of $550,000, or $313,500) The remaining qualified gain (47%, or $258,500) is eligible for the exclusion under the 2 year/5 year rule.  The longer you live in the house, the higher your qualified percentage, but you will never be able to exclude all of the gain.