Here is a good article from kitces.com. It includes a lot of references for you to go look up. Converting A Rental Property Into A Primary Residence
For most people, the exclusion of capital gains on the sale of a primary residence is something that only comes along a few times throughout their lifetime, as individuals and couples move from one home to the next as they pass through the stages of life. However, because the exclusion is available as often as once every 2 years, some homeowners may even try to sell and move and upgrade homes more frequently, to continue to “chain together” sequential capital gains exclusions on progressively larger homes (presuming, of course, that the real estate prices continue to rise in the first place!). However, in some cases taxpayers decided to go even further, taking long-standing rental property, moving into it as a primary residence for 2 years, and then trying to exclude all of the cumulative gains from the real estate (up to the $250,000/$500,000 limits), even though most of the gain had actually accrued prior to the property’s use as a primary residence! The opportunity is especially appealing in the context of rental real estate, as the potential capital gains exposure is often very large, due to the ongoing deductions for depreciation of the property’s cost basis that are taken along the way.
The limit this technique, Congress and the IRS have implemented several restrictions to the Section 121 capital gains exclusion in the case of a primary residence that was previously used as rental real estate. The first, created as part of the original rule under IRC Section 121(d)(6), stipulates that the capital gains exclusion shall not apply to any gains attributable to depreciation since May 6, 1997 (the date the rule was enacted), ensuring that the depreciation recapture will still be taxed (at a maximum rate of 25%).
Example 2a. Harold has a property in 2009 that was purchased for $200,000 and is now worth $350,000. It was rented for a period of years (during which $29,000 of depreciation deductions were taken), and last year Harold moved into the property as a primary residence. The current cost basis is now $171,000 (after depreciation deductions), which means the total potential capital gain is $179,000. However, at the most (subject to further limitations discussed below), Harold will only be eligible to exclude $150,000 of gains (the appreciation above the original cost basis) if he uses the property as a primary residence for the requisite two years, because the $29,000 of depreciation recapture gain is not eligible for the Section 121 exclusion.
In addition to the limitation of Section 121 regarding depreciation recapture, as a part of the Housing Assistance Tax Act of 2008, Congress further limited the exclusion of capital gains for property that was converted from a rental to a primary residence. The new rules, enshrined in IRC Section 121(b)(4), stipulate that the capital gains exclusion is specifically available only for periods during which the property was actually used as a primary residence; any other time (since January 1st, 2009) that the property was not used as a primary residence is deemed “nonqualifying use”. Accordingly, to the extent gains are allocable to periods of nonqualifying use (gains are assumed to be pro-rata over the holding period), those gains are not eligible for the exclusion.
Example 2b. Continuing the earlier example, if Harold had actually rented out the property for four years (2009, 2010, 2011, and 2012) and then used it as a primary residence for two years (2013 and 2014) to qualify for the capital gains exclusion, and sell it next year (after meeting the 2-year use test), the total $150,000 of capital gains (above the original cost) must be allocated between these periods of qualifying and non-qualifying use. Since there are only 2 years of qualifying use out of a total of 6 years the property was held, only 1/3rds of the gains (or $50,000) are deemed qualifying (and will be fully excluded, as $50,000 of qualifying gains is less than the $250,000 maximum amount of qualifying gains that can be excluded). As a result of these limitations, the remaining $100,000 of capital gains attributable to nonqualifying use will be subject to long-term capital gains tax rates (along with the $29,000 of depreciation recapture).
Example 2c. Assume instead that Harold had purchased the property not in 2009, but in 2000, and rented it for 13 years (from 2000 to 2012, inclusive) before moving into the property in early 2013 to live there for 2 years, with a plan to sell in 2015 and maximize the Section 121 capital gains exclusion. Because only nonqualifying use since 2009 counts under IRC Section 121(b)(4), Harold will be deemed to have 4 years of non-qualifying use (2009, 2010, 2011, and 2012), and 11 years of qualifying use (2000-2008 inclusive, and 2013-2014). As a result, 11/15ths of gains, or $110,000, would be qualifying gains eligible to be excluded (and since that’s less than the $250,000 maximum exclusion amount, it would all be excluded), while only 4/15ths of the gains, or $40,000, would be nonqualifying and subject to capital gains taxes. In addition, any depreciation recapture since 2000 would still be taxed as well.
