Thinking of selling your property? The Internal Revenue Service (IRS) considers your home an asset—thus, it's subject to capital gains tax. If your property appreciated in value (and it probably did), you might have to pay taxes on your gains, which could be as high as 20% for long-term capital gains.
However, not everyone has to pay this expensive tax. You might just qualify (without even knowing it yet) for exclusion. The 2-out-of-5-year rule is potentially one of the most advantageous tax laws for homeowners, and it can save you a bucketload of cash come tax season.
The IRS mainly aims to tax property investors—not homeowners. And it uses the 2-out-of-5-year rule to see if you've used the property as a home or an investment.
Below, we'll walk you through the 2-out-of-5-year rule and how to qualify. But first, let's get on the same page about paying capital gains tax on the sale of your home.
Paying Capital Gains Tax on the Sale of Your Home
If you have a gain on the sale of your property (which means you sold it for more than you bought it), that profit could be subject to capital gains taxes. However, $250,000 in profits (or $500,000 when filing jointly) can be excluded if the property qualifies as your primary personal residence.
For example, if you purchased a home for $200,000 and sold it for $400,000, you wouldn't have to report those profits as taxable income because it's less than $250,000. But, if you sold it for $500,000, $50,000 of your profits would be subject to capital gains tax ($500,000 - $200,000 = $300,000, which is $50,000 more than the $250,000 limit).
Not every property qualifies as a primary personal residence, though. To satisfy the IRS's definition, you'll have to pass the 2-out-of-5-year primary residency rule.
What Is 2-Out-of-5-Year Primary Residency Rule?
Investment properties don't qualify for home sale exclusion. But, what's the difference between a primary residence and an investment property? What if you lived in the investment property for a little bit before renting it out to tenants? Does it qualify as a primary residence, then?
The IRS states, "You're eligible for the [home sale] exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale."
Basically, you must have lived in your house for at least 24 months in the 5 years before you sold your home. Those 24 months don't have to be consecutive. 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.
Exceptions to the 2-Out-of-5-Year 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. For starters, the time you spend out of the house on vacation or short-term leave does not get excluded from your 24-month total.
And the IRS has special suspension rules for those on duty in the Uniformed Services, the Foreign Service, or the intelligence community.
If you lived in your primary residence for less than 24 months, you can still exclude a portion of your gains. First, you must qualify under one of the following circumstances:
- You acquired or sold the home using a 1031 exchange
- Divorce or separation
- Death of a spouse
- You were a service member
- Your sale involved vacant land
- The previous home was destroyed or condemned
- You made a work or health-related move
- You gave birth to twins (or more)
To Rent or to Sell? Which Should You Choose?
Selling your investment property may look like a lucrative plan at first glance, but the numbers might not be so appealing once you do the math. After taxes and realtor fees, you might see a much lower payday than you thought.
However, taxes might not be a factor if you qualify for the 2-out-of-5-year primary residence rule.
Renting your property won't give you the big one-time payoff selling does, but it could provide you with reliable ongoing income—and you won't have to eat an expensive tax bill.
Not sure which option is right for you? Let us help.
Nomad can help rent your property (with guaranteed market rent) or sell it. Work with our team of professionals to evaluate your unique circumstances and make the best decision for your situation.