Unfortunately, sometimes dreams don’t come true. In my quest to simplify life, I was blinded by the belief that the rental property I bought in 2003 would also be eligible for the full $250,000 / $500,000 tax-free profit exclusion if I moved back in tomorrow and lived in it for the next two years before selling.
I believed this to be true because I sold a rental property in 2017 that was eligible for the full $250,000 / $500,000 tax-free profit exclusion given I only rented out the property for 2.5 years after living in it for 10 years prior.
With this new rental property I’m considering selling, I lived in the property for two years (2003, 2004), and then have been renting it out for the past 14 years. Even if my family moved back into the rental for two years, we’d only be able to get a prorated tax-free profit exclusion equal to the length of time we lived in the property divided by the entire length of ownership. That’s normally the case for rental properties bought after January 1, 2009, but a law was passed since I bought the property where all use of the rental prior to January 1, 2009 is deemed as “qualified use.”
In other words, the prorated amount of our tax-free profit exclusion would equal Qualified Use / Years of Ownership. Numerator = 2003, 2004, 2005, 2006, 2007, 2008 + 2018, 2019 (moving back in for two years) = 8. Denominator = 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, 2015, 2016, 2017, 2018, 2019 = 17. Prorated amount = 8 / 17 = 47%. If my gain is $720,000, then my tax free gain = 47% X $720,000 = $338,400. With a 27% effective tax rate, my tax savings = $91,368.
Earning tax free profits of $338,400 is better than a poke in the eye, but certainly not as enticing as earning $500,000 in tax free profits as a married couple. And to clarify, I’m not limited to 47% of the $250,000 / $500,000 number. I’m limited to 47% of the gain. That gain is then limited to $250,000 / $500,000. In other words, at a 47% prorated amount, I can have a capital gain of $1,063,829 before I run up to the $500,000 limit as a married couple.