When selling your primary residence, taxes still matter — and they can get complicated. Your home is a capital asset and, therefore, subject to capital gains tax. If your home appreciates in value, you might have to pay taxes on profit. However, there are exceptions.
The 2-Out-of-5-Year Rule Explained
According to the Internal Revenue Service, if you have a capital gain from the sale of your primary residence, you may qualify to exclude up to $250,000 of that gain for individuals and up to $500,000 if you file a joint return. You must meet the ownership and use tests to be eligible for that exclusion.
The 2-out-of-five-year rule states that you must have owned and lived in your home for a minimum of two out of the last five years before the sale. However, these two years don’t have to be consecutive, and you don’t have to live there on the sale date. You can exclude this amount each time you sell your home, but you can only claim this exclusion once every two years. Also, the ownership and occupancy periods don’t have to coincide.
For example, you can live in your home for a year, rent it out for three years, and then move back in for a year before the sale. It will still qualify as a primary residence under IRS guidelines.
Exceptions to the 2-Out-of-5-Year Rule
A vacation or even a short-term absence still counts as time you lived at home, even if you rented it out while you were away. If you became physically or mentally unable to care for yourself and spent time in a facility, that time still counts towards your 2-year residence requirements. The facility must be licensed to care for people with the same condition.
If you lived in your home for fewer than 24 months, you might be able to exclude a portion of the gain. However, you must qualify for the exception due to an extraordinary circ*mstance. Here are exceptions to the eligibility test:
- Separation or divorce
- Death of spouse
- The sale involved vacant land
- You owned a remainder interest and sold that right
- The previous home was destroyed or condemned
- You were a service member at ownership
- You acquired or relinquished the house in a 1031 like-kind exchange
If you don't meet the eligibility test, you may still qualify for a partial exclusion of gain due to the following:
- A work-related move
- A health-related move
- Unforeseeable events such as death, destruction of the home, giving birth to two or more children from one pregnancy, or becoming eligible for unemployment benefits
A partial claim is calculated based on the time spent living in the residence and if you qualify under one of the special circ*mstances.
Here's how the exclusion can be calculated: Count the number of months spent living in the home and divide it by 24. Multiply that number by $250,000 or $500,000 if married. The remaining number is the amount of gain that you can potentially exclude from your taxable income.
The home sale exclusion can considerably lower your tax liability, but you must follow the 2-out-of-5-year rule to be eligible.
How the exclusion can save money for taxpayers
Congress created a capital gains tax deferral for homeowners in 1951, adding Section 112 to the IRC (later Section 1034). If the owner bought another primary residence within a specified time, they could defer recognizing the gain. This rule was complicated, though, and required taxpayers to track accumulated deferrals. In 1964, Congress created Section 121, which allowed one-time exclusions under certain circ*mstances. The limit was for a gain of $125,000 and was only available to taxpayers over 55 who had lived in the home for at least three of the preceding five years. Section 121 did not require the homeowner to purchase a replacement property.
In 1997, Congress repealed Section 1034 and improved Section 121 by removing the age limit and single-use provision. Also, the updated rules increased the exclusion limit to $250,000 for single filers and $500,000 for married couples filing jointly.
Now, taxpayers can use the exclusion more than once as long as they meet the requirements. However, even if the taxpayer has two eligible homes, they can only use the exclusion every two years. If the taxpayer owns two houses and has split their time equally between them over the last five years, both could qualify for the exclusion when sold. But the once every two years provision will prevent the taxpayer from selling both and claiming the exclusion. Instead, they must wait two years between sales.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Hypothetical examples shown are for illustrative purposes only.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
FAQs
When selling a primary residence property, capital gains from the sale can be deducted from the seller's owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale. That is the 2-out-of-5-years rule, in short.
How many times can you use the 2 out of 5 year rule? ›
The 2-Out-of-5-Year Rule Explained
However, these two years don't have to be consecutive, and you don't have to live there on the sale date. You can exclude this amount each time you sell your home, but you can only claim this exclusion once every two years.
What does 2 out of 5 years mean? ›
Under United States tax law, for a home to qualify as a principal residence, it must follow the two out of five year rule. This means that a person must live in the residence for a total of two years or 730 days combined out of a five-year period. This rule also applies to married couples filing jointly.
What is the 2 out of 5 year rule example? ›
You could live in your house for 12 months, rent it out for 2 years, and live in it again for another 12 months to qualify under the 2-out-5-year primary residency rule. Things happen that might prevent you from spending a complete 24 months in your home before selling it, but the IRS provides a handful of exceptions.
How to prove the 2 out of 5 year rule? ›
If you used and owned the property as your principal residence for an aggregated 2 years out of the 5-year period ending on the date of sale, you have met the ownership and use tests for the exclusion. This is true even though the property was used as rental property for the 3 years before the date of the sale.
What is an example of a 2 out of 5 year rule rental property? ›
The two years of on-site residency do not need to be consecutive. For example, a property owner might live in a house for a year, then move and rent it out for 3 years, then move back in for another year before selling; the property would still qualify as a primary residence.
What is 2 out of 5 years capital gains? ›
What Is the 2 Out of 5 Year Rule? In order to qualify for the principal residency exclusion, an owner must pass both ownership and usage tests. The two-out-of-five-year rule states that an owner must have owned the property that is being sold for at least two years (24 months) in the five years prior to the sale.
How do I avoid capital gains on sale of primary residence? ›
You can avoid capital gains tax when you sell your primary residence by buying another house and using the 121 home sale exclusion. In addition, the 1031 like-kind exchange allows investors to defer taxes when they reinvest the proceeds from the sale of an investment property into another investment property.
How long do I have to buy another house to avoid capital gains? ›
You might be able to defer capital gains by buying another home. As long as you sell your first investment property and apply your profits to the purchase of a new investment property within 180 days, you can defer taxes. You might have to place your funds in an escrow account to qualify.
Do I pay taxes to the IRS when I sell my house? ›
If you do not qualify for the exclusion or choose not to take the exclusion, you may owe tax on the gain. Your gain is usually the difference between what you paid for your home and the sale amount. Use Selling Your Home (IRS Publication 523) to: Determine if you have a gain or loss on the sale of your home.
Here are five ways to avoid paying capital gains tax on inherited property.
- Sell the inherited property quickly. ...
- Make the inherited property your primary residence. ...
- Rent the inherited property. ...
- Disclaim the inherited property. ...
- Deduct selling expenses from capital gains.
Capital Gains Tax for People Over 65. For individuals over 65, capital gains tax applies at 0% for long-term gains on assets held over a year and 15% for short-term gains under a year. Despite age, the IRS determines tax based on asset sale profits, with no special breaks for those 65 and older.
How to avoid capital gains tax over 65? ›
Utilize Tax-Advantaged Accounts: Tax-advantaged retirement accounts, such as 401(k)s, Charitable Remainder Trusts, or IRAs, can help seniors reduce their capital gains taxes. Money invested in these accounts grows tax-free, and withdrawals are not taxed until they are taken out in retirement.
What is a simple trick for avoiding capital gains tax on real estate investments? ›
Use a 1031 exchange for real estate
Internal Revenue Code section 1031 provides a way to defer the capital gains tax on the profit you make on the sale of a rental property by rolling the proceeds of the sale into a new property.
Can I depreciate my primary residence if I rent it out? ›
Another benefit of converting a primary residence into a rental is the ability to depreciate the physical improvements, typically over a period of 27.5 years. As IRS Publication 946 explains, depreciation is an expense allowance for the wear and tear, deterioration, or obsolescence of the property.
How does IRS know your primary residence? ›
But if you live in more than one home, the IRS determines your primary residence by: Where you spend the most time. Your legal address listed for tax returns, with the USPS, on your driver's license and on your voter registration card.
How many times can I use the primary residence exclusion? ›
You're only allowed to exclude gain on the sale of a home once every two years. This is true unless the reduced gain exclusion rules apply.
How many times can I claim capital gains exemption? ›
You can sell your primary residence and avoid paying capital gains taxes on the first $250,000 of your profits if your tax-filing status is single, and up to $500,000 if married and filing jointly. The exemption is only available once every two years. But it can, in effect, render the capital gains tax moot.
What are the exceptions to the home sale exclusion two year rule? ›
You, your spouse, a co-owner of the home, or anyone else for whom the home was their residence died, got divorced or legally separated (or were issued a separate decree to pay support to the other spouse), gave birth to two or more children from the same pregnancy, became eligible for unemployment compensation, or were ...
