I'm making up numbers so I can understand how capital gains exclusion will work if I rent part of house in future. Regarding a single, sole-owner person meets the 2 out of 5 year residency test for capital gains exclusion when they sell a house after exactly 10 full years of ownership. Also assume after required adjustments their is a capital gains of exactly $250,000. I understand if that person rented out the entire house for 5 full years during years 3 through 7, then 50% of the days the person owned the house would be "nonqualifying" for capital gains exclusion, thus instead of being able to exclude $250,000 of the gains from tax, they would only be able to exclude $125,000. To contrast, lets now assume the owner only rents out one bedroom of the house that lacked cooking facilities, and the bedroom was 20% of the square footage of the house. The renter and owner both lived in the house during years 3 through 7, and the owner alone lived at the house for 3 years before selling. It was the owners principle residence the entire 10 years. In that case, would there still be nonqualifying days, and if there are would it be adjusted by the square footage of the rented space, such that instead of limiting the excluded amount by a ratio of 0.5 ($125,000), the limitation would be 0.2 (square footage percent) x 0.5 (nonqualilfying days ratio) x $250,000 (capital gains) = $25,000, so $25,000 would be subject to capital gains tax - as opposed to $125,000 if the entire house had been rented for those same 5 years? I have read I.C.R. SEC. 121 "Exclusion of Gain from Sale of Principal Residence," and I've read multiple IRS Publications. All I can gather is the “period of non-qualified use” is any period when the home was used as a rental or investment property and NOT as a principal residence by the owner/seller, but when I explained I was considering thinking about renting out a bedroom again while living in the house as my only and principle residence, I was strongly warned by someone that this could greatly reduce the capital gains I could exclude from taxes. I can't find anything that explains what happens if it is my principle residence, and also how the calculation might be different - if it would be - if I only rented out a bedroom as opposed to the whole house. Could you please clarify?
