If you sell a rental property at a gain, you'll owe capital gains taxes on the transaction. However, if you lived in the home before it became a rental property, you may qualify for a capital gain exclusion of up to $500,000.
Exemptions for Personal Residences
The Internal Revenue Service allows taxpayers a $250,000 capital gain exemption on the sale of a personal residence. The exemption is calculated per person, which means that a married couple could exempt up to $500,000 of capital gains. Say that you and your spouse sold your home for $1,000,000 and your basis was $400,000. Under the personal residence exemption, you can exclude $500,000 of your $600,000 capital gain. You'll only pay taxes on $100,000 worth of gains.
Although you can use the personal residence exclusion multiple times, the IRS only allows you to claim the exemption once every two years.
Exemptions for Rental Properties
If you lived in a house before or after you used it as rental property, you could potentially use the personal residence exemption. For a property to be considered a personal residence, you must have owned and lived in it for two of the most recent five tax years before you sold the property.
For example, say that you lived in a home as a personal residence, rented it out as a rental property for two years, then sold it. Because you lived in the home for three of the last five years, you qualify for the exclusion. However, if the home was rented for four years and then sold, you wouldn't qualify for the exclusion. Practically speaking, you can rent your house for up to three years before selling it and still use the personal residence exemption.
Nonqualified Use for Rental Properties
If your home is a personal residence and then you rent it out for a few years, you're still eligible for the full personal residence exclusion. However, the opposite is not true. Any rental time that occurred before a home was your personal residence isn't eligible for the gain exclusion.
For example, say that you lived in a home for four years, rented it out for one, then sold it. Because the rental period occurred after the home was your personal residence, you're eligible for the full $250,000 or $500,000 exclusion.
Now say you rented out a house for four years, lived in it as a personal residence for four years, then sold it. The IRS considers the four-year rental period before you lived in the home to be nonqualified use. Since the nonqualified rental period comprised half of the time you owned the house, you can only exclude half of the capital gain.