In 2009, Congress modified the exclusion to prevent landlords from being able to use the exclusion to make sale of a rental property tax-free, and focus the benefit of the exclusion on residential owners. This is not well described in publication 523, selling your home, although it is included in the worksheets in the publication. The last time the IRS did a good job explaining it was the 2013 version of publication 523 which you can find online. If you have questions, ask a tax professional. Turbotax does do the calculation correctly.
The short version is that, if you move out of a property and sell it within 3 years (and also meet the 2 year rule before that, meaning you meet both parts of the 2 year/5 year rule) then all your ownership is qualified. But if you rent the property for a while and move back in, that period becomes non-qualified, and you can't exclude that part of the gain.
You also always pay depreciation recapture tax on depreciation you took or could have taken while the home was a rental, which is taxed at your ordinary income tax rate with a cap of 25%.
For example,
a. if you buy in 2010 and use the property as your main residence and sell in 2019, all the time you owned the property is qualified.
b. if you buy in 2010 and use the property as your main residence until 2017, then convert to a rental, then sell in 2019, all your ownership period is qualified, but you owe recapture tax.
c. if you buy in 2010 and use the property as your main residence until 2013, then convert to a rental for 3 years until 2016, then move back in as your main residence and sell in 2019, those 3 years are non-qualified and you owe capital gains tax on 3/9th of your gain, even though you meet the 2 year/5 year rule to use the exclusion on the other 6/9th of your gain. (Plus, you still pay recapture tax.)
Taking example c., you owned the home for 9 years and have 3 years of non-qualified use. That means that only 6/9th of the capital gains is qualified for the exclusion, and the other 3/9th is subject to capital gains tax. You can exclude up to $250,000 of qualified gain, but must pay capital gains tax on the non-qualified gain. So let's suppose you bought for $150,000 and sold for $350,000. You took or could have taken $15,000 of depreciation, so your adjusted cost basis is $135,000 and your gain is $215,000. You first pay recapture tax on $15,000 at your ordinary income tax rate (12%, 22%, 24%, or a maximum of 25%). Then, $66,666 of the gain is non-qualified and you pay 15% long term capital gains on that. The final $133,333 of gain is qualified for the exclusion and, since it is less than $250,000, you can exclude the entire remaining $133,333 from capital gains tax.
An extra wrinkle is that the term of non-qualified use only begins in 2009 when the law was changed.
So let's suppose that, for house #1, you owned it since 2000 and it was exclusively a rental. You move into the home as your main residence in 2017 with the intention of selling in 2019 and using the exclusion. In 2019 when you sell the home, you have 11 years of qualified use (2000-2008 and 2017-2019) and therefore can exclude 11/19th of the gain. Again, start by figuring your total gain, using your adjusted cost basis (cost minus depreciation you took or could have taken). You pay recapture tax on the part of the gain due to depreciation, and you pay long term capital gains tax on the 8/19ths of the gain attributed to a period of non-qualified use,, and you can exclude the other 11/19ths of gain from capital gains tax up to the maximum exclusion of $250,000 or $500,000 if married filing jointly. There is a worksheet in publication 523 to help with this, and your periods of qualified and non-qualified ownership are calculated to the day (such as 6234 qualified days out of 9431 total days of ownership) so you will need the date of purchase, the date of sale, and the dates you converted to a rental and back to your main residence. In the case of a home owned since before 1/1/2009, all your ownership before 1/1/2009 is considered qualified even if the home was a rental.
(Your gain calculation is also adjusted for capital improvements that you might have made, such as a new roof, new furnace, and the depreciation you took or could have taken on those improvements. Landlords obviously need to keep excellent financial records as long as they own the property, and if audited, the IRS does not have to award any basis adjustment you can't satisfactorily prove)
Now let's look at house #2 which was previously your main residence and is now rented. If you sell within 3 years, and therefore meet the 2 year/5 year rule, all your gain is excluded and you only have to account for depreciation recapture. But, if you move back in as your main residence for 2 more years, then the rental period is now considered non-qualified and part of your gain is now taxable. Let's say that as of now you owned the home for 8 years and moved out 2 years ago. If you sell today, all the gain (except for depreciation recapture) is excludable up to the $250,000 limit (or $500,000 if married filing jointly.) If you move back in 2019 and sell in 2021, then you have 10 total years of ownership but only 8/10 is qualified for the exclusion, you can exclude that gain but 2/10 of your gain will be taxable (plus recapture).
You can only use the exclusion if you meet the 2 year/5 year rule and the closing date of the sale is more than 2 years since the last time you closed a sale and used the exclusion. So if you close on home #1 on June 25, 2019 and use the exclusion on your 2019 tax return, the earliest you can use the exclusion on home #2 is June 26, 2021.
Depending on the amount of appreciation in value, the amount of depreciation recapture in each case, and other factors, you will need to consider very carefully whether you want to sell home #2 before January 2020 without moving back in and use the full exclusion (and not use the exclusion on home #1); or use the exclusion on home #1 and sell home #2 without using the exclusion; or sell home #1 in 2019, move back to home #2 and sell in 2021, and use a partial exclusion in both cases. Expert tax advice from a full time tax professional (not a seasonal storefront) may be desirable.
