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.

If you decided to sell your house to simply life, lock in gains, downsize, or relocate for a job, this article will help you minimize your tax bill.

According to the IRS, most home sellers do not incur capital gains due to the $250,000 and $500,000 exclusion for single and married couples. This makes sense since the median home price is roughly $210,000 in 2018, and the average holding period is nine years.

There are three tests you must meet in order to treat the gain from the sale of your main home as tax-free up to $250,000 / $500,000:

• Ownership: You must have owned the home for at least two years during the five years prior to the date of your sale. It doesn’t have to be continuous, nor does it have to be the two years immediately preceding the sale.
• Use: You must have used the home you are selling as your principal residence for at least two of the five years prior to the date of sale.
• Timing: You have not excluded the gain on the sale of another home within two years prior to this sale.

But let’s say you plan to sell a property in an expensive coastal city where your gains are much greater than $250,000 / $500,000. There’s a good chance you still won’t owe much in capital gains tax if any if you keep proper records.