Capital gains question (2-out-of-5-Year Rule)

Monica Seth · 2021-05-17T11:52:25-07:00

Thank you in advance forum members. I need clarification on whether the 2-out-of-5-Year Rule would apply in our situation to get full exclusion from capital gains tax.We live in CA and had purchased a condo in Jan 2005. This was our primary residence and we lived there from Jan 2005 until Nov 2017. It was converted it into a rental property from December 2017 - April 2021.Tenant moved out in April. Since tenant lived there for 3 years 5 months ,we are considering moving back into the condo as our primary residence for 5 months and then selling it in October 2021. That way it would be owner occupied for 2 years out of the past 5 years, so we are hoping to get full exclusion on capital gains tax.Is my understanding accurate? Would the 2-out-of-5-Year Rule apply in our situation to get full exclusion from capital gains tax? We don’t own any other primary residence; we are renting a home nearby. The total depreciation deducted over the 3 years 5 months is $ 28,887. I understand we are liable for depreciation recapture when we sell. Is that a flat 25% or based on our tax bracket? We are aware of the 1031 exchange and do not want to do an exchange currently. Thank you!

Wayne Brooks

Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes

5y

@Monica Seth

No, for a couple of reasons....

1) moving back in for 6 months Still won’t get you to the 2 (24 mo.s) years of the last 5 years (60 mo.s)..you still have that 3 years 4 months (40 mo.) gap in there.

Every month going forward, you lose one month that you lived there before you rented it, as you look back 60 months from your Sale date....so you can’t meet the rule unless you move back in for 2 years.

2) If you moved back in for 2 whole years, to meet to 2 out of 5 rule, you still won’t get the full exclusion because you met the 2 out of 5 rule After it was a rental. Then your exclusion is pro rated by the number of months it was a rental verses the number of months it was a rental.

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Monica Seth

OP

CA · Member since 2016 · 8 posts · 0 votes

5y

Hello Wayne Brooks. Thank you for replying. I appreciate your help.

Based on your post,what I understood is that the property should be a primary residence for 60 months continuously before the sale date to qualify for 2 out of 5 year rule for capital gains tax . Did I understand correctly?

I now understand that the exclusion is pro rated by the number of months it was a rental vs the number of months it was a primary residence.

However, could you please clarify if it has to be a primary residence for 2 years continuous immediately prior to the sale date?

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Monica Seth

OP

CA · Member since 2016 · 8 posts · 0 votes

5y

Wayne Brooks - this is what I found on the IRS website. https://www.irs.gov/taxtopics/...

"In general, to qualify for the Section 121 exclusion, you must meet both
the ownership test and the use test. You're eligible for the exclusion
if you have owned and used your home as your main home for a period
aggregating at least two years out of the five years prior to its date
of sale. You can meet the ownership and use tests during different
2-year periods."

Based on this , my understanding is that the 2 years must not be consecutive to qualify.

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Bill B.

Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes

5y

It does not have to be the 2 years right before the sale.

it does not have to be 24 or 60 months continuously.

it does have to be 24 of the LAST 60 months. (If you move in now your previous use is rolling off, that’s why you can’t do just 6 months.)

because when you sell it will have been a rental BEFORE it was your primary, in the qualifying 2 out of 5 years you have to prorate the tax free deduction.

I know it’s too late now, but you REALLY should have sold in November 2020. It doubtful you made more in those 4 months than you’re going to end up paying in taxes, prorated or not.

2 Reply

Wayne Brooks

Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes

5y

@Monica Seth No, it only has to be 24 out of the last 60 months to meet the basics of the rule..... but you can’t do that now without moving back in for 2 whole years. The intent of the law was to encourage home ownership, this is why you only get the full exclusion of your 2 plus years starts when you buy it, then you can rent it for no more than 2 years After meeting the 2 year minimum.
If you meet the 2 years (out of the last 5) After it has been a rental, then the exclusion gets prorated.

0 Reply

Monica Seth

OP

CA · Member since 2016 · 8 posts · 0 votes

5y

Thank you Bill Brandt and Wayne Brooks. Home prices in CA are at the highest I have seen in the past few years. I was hoping to sell at a higher price now and then later when the prices stabilized wanted to buy a single family home.
Since I am not eligible for the Section 121 exclusion, what would your advice be?

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Bill B.

Investor · Las Vegas, NV · Member since 2013 · 8k+ posts · 10k+ votes

5y

I would never sell hoping to buying the future at a lower price. It has to drop 10% just to cover selling costs, and another 10% to cover taxes paid. If I had a crystal ball it would say “ain’t gonna happen”. If you’re paying rent feel free to move back in to it. If you own another home you live in already, keep renting it out unless you plan to sell and never buy again.

If you plan to retire somewhere else you could sell and do a 1031 exchange for that property. (I know you said you weren’t interested in 1031 but this is a twist to another future retirement home.)

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Monica Seth

OP

CA · Member since 2016 · 8 posts · 0 votes

5y

Bill, thank you for the suggestions. Appreciate it! We don't own another home. We are renting a single family home and my spouse was going to move back to the condo if it was going to make us eligible for Section 121 exclusion. It doesn't work for our entire family to move back to the condo. Our family has grown and our children would have to change schools if we moved to the condo. So that is not an option.

I understand our only choice is to keep renting the condo currently. I noticed you mentioned If you plan to retire somewhere else , you could sell and do a 1031 exchange for that property. Why would it work to our benefit only if we plan to retire someone else besides California?

Quick question : When we do a 1031 exchange, does it have to be an investment property? Or could it be a primary residence?

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Capital gains question (2-out-of-5-Year Rule)

Capital gains question (2-out-of-5-Year Rule)

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