2 out of 5 year rule

[bmon123]

Situation: 

Dec 10 will be 3 years we have rented our home. We lived in it the previous 2 years as a primary residence.

We currently have our house up for sale. If the home goes under contract by the 10th do we qualify for the 2/5 yr rule or must it close by Dec 10th?

We only deduced expenses including repairs and maintenance on the home during the 3 years.

If we sell the home after this time how are we affected by the rule?

Looking to understand if best to hold on to the house or still sell if after Dec 10th. and to avoid capital gains taxes if possible. 

Thanks in advance as the rule seems complicated.

[Mike9241]

contract means nothing. starting on the date you closed on the purchase and ending 5 years later which if you closed on the purchase on 12/10/19 the 5 years ends 12/09/2024. You can close on 12/10/2024 because the 5-year lookback period for ownership and occupancy starts the day before closing.

did you depreciate the property when it was a rental? if not, you may want the services of a tax pro because the law requires that you reduce the basis by the amount of the depreciation that should have been taken while it was a rental. any gain based on that reduced basis is subject to section 1250 recapture. the depreciation recapture applies before the home sale exclusion.

 repairs do not add to your tax basis only improvements. 

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there is no way to avoid the depreciation recapture and if you wait past the 5 year mark you lose the home sale exclusion.   waiting until the last day to close is foolish. sometimes closing fails and then you would lose the $250k single or Married filing separately / $500K married filing jointly (assuming both meet the 2-year occupancy test) exclusion.

[Carl]

To be more specific, which to me seems to simplify it better, you must have lived in the property as your primary residence for at least 730 days (2 years) of last 1826 days (5 years) you owned it, counting back from the closing date of the dale.

[NCperson]

@bmon123 - "hold on to the house"

I assume you mean maybe you should hold onto the home and live in it again, so that you can meet the 2 of 5 rule.  but living in the home after renting it creates other complications - the IRS / Congress created rules so that taxpayers wouldn't get the full benefit of the capital gains exclusion.  

[Opus 17]

I'm sorry but you have several problems here.

If the home goes under contract by the 10th do we qualify for the 2/5 yr rule or must it close by Dec 10th?

You must close by 3 years (1095 days) from when you stopped using the home as your main residence.

We only deduced expenses including repairs and maintenance on the home during the 3 years.

This was a mistake.  You should have claimed depreciation.  When you sell the home, you must pay depreciation recapture on the depreciation you took or could have taken.  Depreciation recapture is taxed at a higher rate than ordinary capital gains.  If you want to claim the depreciation deduction to get some retroactive tax benefits, it is too late to file amended returns since you used an improper depreciation method.  You must file a form 3115 to fix the depreciation, and this form usually requires professional assistance.  It is not included with Turbotax.

If we sell the home after this time how are we affected by the rule?

If you sell more than 3 years after moving all, all the gain is taxable.  Long term capital gains are taxed at zero%, 15% or 20% depending on your other income and filing status (a bit less than the tax rate for ordinary income).  However, the part of the gain that is due to depreciation that you should have taken will be taxed as ordinary income at 12%, 22% or 24%.  

Because you would have a taxable capital gain, it might be a good time to sell other capital property that has resulted in a loss, because you can deduct the loss against the gain (like stocks or other investments that have lost money).  

Looking to understand if best to hold on to the house or still sell if after Dec 10th. and to avoid capital gains taxes if possible. 

Because you have moved out, you can never avoid capital gains even if you move back in.  This creates a situation called "non-qualified use."  As an example, suppose you bought the house in 2018, rented in 2020, moved back in 2023, and sell in 2025.  Even though you would meet the 2 year rule in 2025, the rental period is non-qualified, and the gains attributed to that period of ownership are not eligible for the exclusion.  In that example, you owned the home for 7 years and lived in it for 4 years, so 3/7 of the gain is non-qualified and fully taxable, and 4/7 is qualified for the exclusion.  

[glee308995]

This is the saddest answer I came across on the internet today 😭

I left NJ/US in 2018 and rented out my house, it was meant to be just 2 years.  Then came the pandemic and I ended up overseas until now because of the kid in school.  I was trying to see how I can move back to NJ for 2 years and re-qualify for the 2 out of 5 rule and came across this.

[Opus 17]

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@glee308995 wrote:

This is the saddest answer I came across on the internet today 😭

I left NJ/US in 2018 and rented out my house, it was meant to be just 2 years.  Then came the pandemic and I ended up overseas until now because of the kid in school.  I was trying to see how I can move back to NJ for 2 years and re-qualify for the 2 out of 5 rule and came across this.

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If you were overseas due to being in the military, US foreign service, or peace corps, you can get up to a 10 year extension on the 5 year rule and you could qualify for a full exclusion if you sell the home without moving back into it.  (But, you still have to pay recapture on the depreciation you took or could have taken while it was a rental.)  The details are here on pages 4-6.

https://www.irs.gov/pub/irs-pdf/p523.pdf

If not overseas due to government service, if you move back into the home for 2 years, you at least qualify for a partial exclusion.  

[Carl]

Just to provide more clarification here, and I'll start by stating:

You must have lived in the house for at least 730 days of the last 1826 days you owned it. The "lived in" period of time does not have to be consecutive either, so long as it is all within the last 1826 days you owned the property, counting backwards from the closing date of the sale.

if you lived in the property for less than 730 days "AND" your move was because of military PCS oriders (there are other reasons I'm not getting into here), then you can still qualify for a partial exclusion. Additionally, if it was a military directed PCS move, the day count for both "lived in" and "owned" is not extended. It is "SUSPENDED". In other words, you stop counting days. Example:

You purchase the home on Jan 1, 2010 (the closing date) and you move in that same day and actually sleep in the property that night, Jan 1 is day one of ownership and day 1 of having lived in the property as your primary residence.
Less than 2 years later you get PCS orders to another location with a reporting date of Dec 1, 2012. You'll be at least a month short on the 2 year requirement. (Actually more than a month in reality, since you have to allow for pack-out and travel time.)  Let's say you want to take 30 days leave before your reporting date to, so you can visit family before reporting to your next duty station overseas. The HHG packout crew shows up on Oct 31st and packs you out, which means you're staying in a hotel that night, as your flight leaves on Nov 1st. Oct31st is the last day you lived in the property as your primary residence. So it was your primary residence for 669 days. You "WILL" qualify for a partial exclusion because your move is not your choice. The military is ordering you to relocate basically. The day count for period of time you owned the property stops on the day you depart the area, which is Nov 1st. So you've owned it for 770 days. Note that the day count for both residency and ownership is not extended. It is "suspended". You just top counting. The day counts will resume when any one of three things happens in the future.
1) The day you relocate to the area on a permanent basis for "any" reasons. (retirement, separation, PCS orders, etc.)
2) The day you retire or separate from the service.
3) Nov 1st, 2022. This is exactly 10 years after you departed the area.
The day counts resume when "any" "one" of the above 3 possibilities occurs.