Using the "2 out of 5" rule on rented property.

[Rodney Bentley]

My in-laws are considering selling their old home, now rented to us, in the next couple of years and we want to mitigate as much tax obligation as possible. If one of them was to use the property as a primary residence for two years would they be eligible for the $250,000 tax reduction or is there some prorating for the period of time it was rented?

Other info- My in-laws purchased the CA home back in the 70's as a primary residence and lived there until about 2007 (moved to new residence).  The property was vacant from then until 2011 when we moved in. It had some flood damage in 2009 and was renovated the next year. The property was paid off around 2005 and an equity line was taken out on it in 2010 to finance the renovation. The property has only been rented to the owners' child and at below market value (love the child discount ;). The sale price, less basis, is not likely to exceed $250,000. Thanks.

[Dave Foster]

@Rodney Bentley, At this point in time they would be converting an investment property into a primary residence.  Could be done but they will only get to prorate between the amount of "qualified use" (as a primary residence and "Non-qualified use (as a rental).  They would also have to recapture all depreciation since 2007 which would be substantial as well.

At this point they're probably better of selling as an investment property and using a 1031 exchange to move into passive management or better cash flow.  It would only be tax deferred as opposed to tax free but they can defer all the tax.  I fear you'd still have a substantial tax bill with a conversion.