Qualifying for Tax-Free Treatment When Selling a House

When homeowners can sell their primary residence, the first $250,000 in profits are tax-free. The tax-free amount is doubled to $500,000 for married people filing a joint return. In order to qualify for this tax exclusion, people need to live in and own their house for at least two years in the five-year period that ends on the date of sale.

A frequent scenario is the homeowners will decide to rent out the house while they wait for market conditions to improve. Homeowners will still be able to exclude their gain, but will need to pay close attention to the two years they need to qualify for the exclusion. When deciding to sell, homeowners will need to figure out if they have used the property as a primary residence long enough to meet this two year test.

One reader emailed me to with the following scenario:

"I just read your article on Capital gains. Me and my wife lived in our main house for over 3 years and then moved to another house although our previous main house never sold so we just started renting it out. When does my 5 year cut-off for capital gains begin? Our 5 years will be this December. I just don't know if that pushes my 5 year limit back due to it being a rental. The renters say they may decide to purchase the house but I may force their hand if my 5 year window closes in December. Could you please clarify my situation?"

Here, the couple needs to know what is the last day they can sell their rental property and still be eligible for the exclusion. To qualify for the exclusion, they will need at least two years (24 months, or 730 days) when they lived in the house. These days "do not have to be continuous," as the IRS points out in Publication 523 in the section the ownership and use tests. (A point which will enable this couple to do some planning, as we'll see.)

Since they need at least 730 days to qualify, they could sell their rental property as late as three years after the date it was placed in service as a rental property. If they sell the house after this cut-off date, they will lose their eligibility to claim the tax exclusion. But they can always decide to move back into the house and live there long enough to get to the number of days they need. The IRS explains the details in Publication 523, in the section on business use or rental of home.