Sale of primary residence not lived in for a full 2 years

[ztard]

If I lived in the house for 1.5 years in the past 5 years, do I get partial credit of the $500k capital gains exemption or is it all or nothing?

[Opus 17]

You can qualify for a partial exclusion if the reason you are selling in less than 2 years is a hardship -- hardship in this case means military orders, a change in job requiring a move of more than 50 miles, or a change in life circumstances that forces you to change houses and that was unforeseeable when you bought the current house.

(One example the IRS gives is, if you have a 2 bedroom house and give brith to twins, it might be a "hardship" justifying a move to a 3 bedroom house.  But if you had the twins already and decided to try the 2 bedroom but it didn't work out, then that doesn't count because it was not unforeseeable.)

You don't submit proof of a hardship with your tax return, but keep it with your important papers for at least 3 years (7 is better) in case of audit.

[Opus 17]

If you don't qualify for the hardship exception then it is all or nothing.  You owe tax on the entire gain if you move in less than 2 years, and you owe tax on the gain if you moved out 3.5 years ago so only get credit for 1.5 of the past 5 years.

[ztard]

Now I need to expand the understanding of the situation. House 1 is 100% rental. I moved out over 5 years ago because we needed more space for my first kid. House 2 I have been living in and my wife gave birth to twins 3 years ago. Space is getting tight, the school my older kid got into is horrible and a pot dispensary has been approved to open near the neighborhood. I want to sell House 1 and move somewhere else and rent out House 2. Do I qualify for hardship?

[Opus 17]

No.  The hardship only applies to seeking within 2 years of buying.  I didn't read your question closely enough.  

Because house 1 has been a rental for more than 5 years there is no exclusion for the gain on house 1.  

If you sold house 2, you would not qualify for a hardship since the kids are 3 years old so even if you bought house 2 less than 3 years ago it was not unforeseeble that house 2 might be two small.  If you have owned and lived in house 2 more than 2 years you qualify for the ordinary exclusion if you sell now or if you rent it for less than 3 years before selling.

[ztard]

What if a medicinal pot dispensary opens up close by? I don't want my kids anywhere near that and it's going to bring in more crime.

[ztard]

And the school lottery system stuck my kid into a pretty horrible school so I want to move specifically for that reason.

[Opus 17]

So I took another look at the rules.  <a rel="nofollow" target="_blank" href="https://www.irs.gov/publications/p523/ar02.html#en_US_2016_publink1000200611">https://www.irs.gov/pu...>

House #1 will never qualify since you have not lived there in the past 5 years.  The fact that the ultimate motivation for selling is a change in circumstances at your main residence does not allow you to avoid capital gains on rental property.  The exclusion rule was put in place to ease the tax burdens on people who own and occupy their personal main residence.  It simply doesn't apply to rental property outside of the 5 year rule.

You might qualify on house #2 because the rule does not specifically mention selling, it only mentions moving.  This is a more complicated issue.  But I can't tell from your various comments, when you moved into house #2 and when you bought house #2.  Because if you owned it prior, and moved into it with your larger family, you can qualify for an exclusion but you also have to deal with the "non-qualified period" rule (which is complicated and not well-explained in the current documents.)  So when did you buy house 2 and when did you move into house 2, and when do you plan to move out?

[ztard]

House 2 is up for debate if I sell or turn it into an investment property. If I decide to sell, it is 100% because my kids need more space, the school my older son was accepted to is horrible and there's a medicinal pot dispensary opening close by. I was hoping to use hardship rules on either or both properties.

[Opus 17]

If you sell house #2, and you have owned and lived in house #2 for less than 2 years, you can use a partial exclusion by reason of hardship.  Note that the tax law doesn't actually say "hardship", it says "such sale or exchange is by reason of a change in place of employment, health, or, to the extent provided in regulations, unforeseen circumstances".  Unforseen circumstances are covered on page 4 here, if you believe you have an unforeseen circumstance that will give you a partial exclusion, keep good records in case of audit.

I think you would also qualify for the partial exclusion if you converted to a rental as long as you sold within the next 3 years -- if you hold it longer than 3 years, you would lose the ability to use the exclusion based on the regular 5 year rule.  (The unforeseen circumstance rule doesn't give you a blanket exemption -- it only means that if the *only* reason you don't qualify is because of not living there 2 years due to a qualifying circumstance, you can use a partial exclusion.  If you fail to qualify for other reasons, like the 5 year rule, you can't use the hardship rule to get around it.)  If you held the property for less than 3 years and qualify for the exclusion but for the two year rule, I don't see a ban o