Home Sale Exclusion After Renting It Out: the facts

1. The home-sale exclusion ($250,000, $500,000 joint) is for a principal residence owned and used two of the last five years. A home rented out before you moved in is partly outside it: the share of the gain matching the rental years after 2008 is not excludable (§ 121(b)(5)).
2. The order matters. Renting BEFORE moving in creates nonqualified use; renting AFTER moving out, within the five-year window, does not (§ 121(b)(5)(C)(ii)). A house you lived in and then rented for two years before selling keeps its full exclusion.
3. Depreciation taken while the home was rented is never excludable and is taxed at up to 25 percent when the home is sold (§ 121(d)(6); § 1(h)(6)), whether or not it was actually claimed on the returns.
4. Example: a home bought for $400,000, rented four of ten years before the owners moved in, with $40,000 of depreciation, sold for $900,000 on a joint return: 40% of the $500,000 gain ($200,000) is taxable, the depreciation is taxed at 25 percent, and the rest is excluded: $40,000 of tax, against $10,000 had it never been rented.
5. The allocation is by time owned, not by value: a year of rental in a flat market costs the same share as a year in a rising one.
6. A rental converted to a residence is common for people who move into a second home in retirement; the two-year use test starts when they move in, and the years before it count against them forever.

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