You Moved Out and Rented Your Old House. What Can You Still Exclude?

Plenty of people end up as accidental landlords. They move for work, buy a bigger house, or keep the old place because the market was poor. The house becomes a rental, and years later they wonder what happens when they sell.

Two provisions can apply: the home sale exclusion under Section 121 and a 1031 exchange. Which one is available, and how much it is worth, depends on the order of events and on how long each phase lasted.

Does renting your old home lose the exclusion?

Not immediately. The exclusion generally requires that you owned and used the property as your principal residence for at least two of the five years before the sale.

That is a five year lookback. If you lived in the house for at least two years and then rented it, you can typically still claim the exclusion for up to three years after moving out. Sell within that window and up to 250,000 dollars of gain, or 500,000 dollars for a married couple filing jointly, may be excluded.

Miss the window and the exclusion is generally unavailable, because you no longer meet the two out of five years test.

What is the nonqualified use rule?

A separate rule, applying to periods after 2008, that reduces the exclusion in proportion to time the property was not used as your principal residence.

The important detail, and the one that surprises people, is that it generally applies to nonqualified use before the property became your residence, not to rental periods after you moved out permanently within the five year window.

So the pattern of living in a home first and renting it afterwards is treated relatively favourably. The pattern of renting first and moving in later is treated less favourably, which is exactly the opposite of what many people assume.

What about depreciation?

Depreciation claimed while the property was a rental, for periods after May 6 1997, is not excluded. It is generally taxed as unrecaptured gain at up to 25 percent when you sell, even if the rest of the gain is excluded.

This catches people who assume the exclusion covers everything. If you rented for several years and claimed depreciation, expect a bill on that portion.

Can you use a 1031 exchange instead?

Yes, if the property has genuinely become investment property. A former residence that has been rented at market rates for a meaningful period can be exchanged, deferring the gain including the depreciation recapture.

Which route is better depends on the numbers. The exclusion is permanent and requires no reinvestment, so it is usually preferable when it is available and covers most of the gain. An exchange defers rather than excludes but has no dollar limit, so it is often better for large gains or when the exclusion has expired.

Can both apply to the same sale?

In some circumstances, yes. Where a property qualifies for the exclusion and is also investment property, the exclusion can be applied first and the remaining gain deferred through an exchange. The mechanics are technical and need to be set up before closing, including engaging a Qualified Intermediary.

What does the timing look like in practice?

• ›Moved out one year ago, want to sell now. The exclusion is likely available in full, subject to depreciation recapture.
• ›Moved out four years ago, still renting. The two out of five years test has probably failed. An exchange may be the better route.
• ›Moved out two and a half years ago. The exclusion window is closing. The sale date may be worth several tens of thousands of dollars.
• ›Rented it first, then moved in. Nonqualified use rules are likely to reduce the exclusion, and if the property was acquired in an earlier exchange, a five year ownership requirement also applies.

What records matter?

Dates of residence and rental, leases, depreciation schedules, and evidence of residence such as tax returns, voter registration and utility bills. Reconstructing this later is difficult, and the numbers turn on it.

What if you are unsure which route is better?

Ask your CPA to calculate three numbers on the same page:

• ›The exclusion route. Sale price less basis, less the excluded amount, plus tax on depreciation recapture and any gain above the exclusion.
• ›The exchange route. Full deferral, with the gain carried into the replacement property at a lower basis.
• ›A straight sale. All four taxes, so you can see what doing nothing costs.

For a modest gain within the exclusion limit, the exclusion usually wins because it is permanent and requires no reinvestment. For a large gain, an exchange often wins because the exclusion is capped. For a gain that sits between the two, the answer depends on what you intend to do with the money.

Does the five year rule apply here?

Only if the property was itself acquired through a 1031 exchange. In that case the exclusion cannot be used until five years after the exchange acquisition, regardless of how long you have lived there. A home you bought normally and later rented is not subject to that rule.

What to do first

Write down the exact dates you lived in the property and the dates it was rented, then count backwards five years from a realistic sale date. If you are inside the window, discuss timing with your CPA, because a few months can decide whether a large exclusion applies. If you are outside it, model an exchange instead.

Nothing here is tax, legal or investment advice. These rules are technical and depend on your dates and circumstances. Confirm your position with your CPA before selling.