Yet another 2 out of 5 year Primary/Rental Ratio question (sorry)

[Peter J Donaldson]

Ok, I have read all the IRS publications and seen many forum answers on this basic subject and I THINK I now have an answer from IRS publication 523 but would like confirmation if possible as I think I have a quite rare scenario. Sorry for the long detailed post, but here is my situation:

• Bought a single family house in 2003 and used as primary residence until April 2016.
• Rented it and it has been rented continuously since.  Our tenant is coming to the end of their 3rd year leasing. In the middle of April 2019, it will have been rented for exactly 3 years. (I obviously have owned it for far more than the 2 years preceding).
• My tenant is moving out at the end of the lease
• So, let's say we decide NOT to rent it again, but sell it, manage to find a buyer and close (for example) 25 days after the lease ends, in early May.
• Then looking at the timeframe, for 3 years and 25 days prior to the date of sale, it was NOT our primary residence and for the previous 705, it WAS our primary residence.
• If the required 2/5 year ratio is exact to the day, then theoretically we do not meet the 2/5 ratio even a single day after the 3 years of rental expires. That then jeopardizes our ability to avoid the capital gains.
• The rules say you can specify months or days in the calculation of how much time it was your primary residence. Could I still say 24 months until we fall below the 23 month point around the middle of May, meaning I have 30 days grace before I am officially at less than the 2/5 ratio, or do you no longer meet the ratio when your period of primary residency goes down by just one day from the 730 days which would be the 2 year minimum within the last 5 years?
• Even if it is a hard line, I am thinking now that it may only be a hard line for whether you can avoid all the capital gain. Partial exclusion seems like it may be a possibility in my case.
• The same IRS publication says that even if you do not quality for the 2/5 rule (without clarifying how exact that ratio needs to be), if you move because of a work need, you can qualify for a partial exclusion:
  • You took or were transferred to a new job in a work location at least 50 miles farther from the home than your old work location. For example, your old work location was 15 miles from the home and your new work location is 65 miles from the home.
• This is in fact my situation. I took a new job in a different state and that was the primary reason for having to leave and rent the house. 
• The same question applies in terms of ratios for the partial exclusion though. The partial exclusion worksheet in Pub 523  says:
  • Step 1. Your time of residence in the home during the 5-year period leading up to the sale (and Step 1 also covers some other options that do not apply to me)
  • Step 2. Take the smallest period from Step 1 (you may use days or months) and divide that number by 730 (if using days) or 24 (if using months)
    
  • Multiply the result from Step 2 by $250,000. Stop here if not married filing jointly
    
  • Repeat Steps 1–3 for your spouse and add the two results
    
• If you can use fractions when you divide the primary residence period by 730, that means that If I close 25 days after the end of lease date then maybe my answer is 705/730=0.96 * $500K, so I can exclude up to $483K of the gain (also to be adjusted by the depreciation I have taken in the last 3 years). Is that correct? If it is 6 months after the lease expires then my answer is 75% so I can avoid $375K of gain adjusted by depreciation taken. In that case I don't really have a lot to worry about in terms of trying to close on a sale as soon as possible after the lease ends, as the percentage exclusion goes down relatively slowly.

Everyone's basic online answer always seems to go back to restating the 2/5 year ratio and I have an unfortunate case when the first opportunity to sell it is immediately after exactly 3 years of renting. Nobody has clarified that ratio question, not even really the IRS in my view. 

My quandry is whether I need to arrange a 1031 as part of the sale to avoid the gains, but then I am faced with identifying 3 properties within 45 days and closing in 180 days. I also do not think that there are many investment opportunities with the few hundred K I am likely to have out here in Northern California. I feel like I may be better keeping and investing the money in other ways for now until a better real estate opportunity arises if I can indeed avoid capital gains tax on the sale. 

Going down the 1031 exchange route could therefore leave me with a different problem if I cannot find anywhere new to buy. If I do NOT qualify for either full or partial exclusion of Capital gains I may have no choice though, as I cannot just let $150K or so just walk out the door to the IRS.

FYI I have been taking depreciation on the rental properly for the last 3 years - total about $37K. Potential gain on the house depends on selling price, but may have appreciated around $200-$220 (60-70%) since we bought it in 2003.

If anyone can put my mind at ease on the "less than 1.0 ratio" being allowed, I would be very grateful.