Can You Claim the Capital Gains Exclusion if Your Residence Was a Rental?

Selling a home can have significant tax implications, especially if it was previously used as a rental. The IRS allows homeowners to exclude up to $250,000 ($500,000 for married couples) of capital gains on the sale of a primary residence, but specific conditions must be met. If the home was rented before being occupied as a primary residence, this can affect eligibility for the exclusion.

Requirements for Residence Classification

To qualify for the capital gains exclusion, the property must be classified as a primary residence. This determination is based on the ownership and use tests, both of which must be met. The ownership test requires that the homeowner has owned the property for at least two out of the five years before the sale. The use test requires that the homeowner has lived in the home as their main residence for at least two of those same five years. These years do not need to be consecutive.

The IRS considers various factors to determine if a home qualifies as a primary residence, including the address on tax returns, voter registration, driver’s license, utility bills, and where mail is received. Other indicators include the location of bank accounts and where children attend school. If audited, clear documentation is essential.

Temporary absences, such as extended travel or work assignments, do not necessarily disrupt the use test as long as there was intent to return. However, if the home was rented out during an absence, the IRS may scrutinize whether it remained a primary residence or became an investment property.

Impact of Rental Usage on the Exclusion

Using a home as a rental before selling can limit the gain eligible for exclusion. Even if the ownership and use tests are met, any period of non-qualified use—when the home was not a primary residence—reduces the exclusion proportionally.

The Housing Assistance Tax Act of 2008 requires gains to be allocated based on the time the property was used as a rental versus a primary residence. Non-qualified use applies to periods after 2008 when the home was rented or used as a second home. The portion of the gain corresponding to these rental years is taxable, while the remainder may still qualify for exclusion.

For example, if a homeowner owned a property for ten years, lived in it for four, and rented it for six, only 40% of the gain (4 out of 10 years) could be excluded. The remaining 60% would be subject to capital gains tax.

There are exceptions. If rental use occurred before the home became a primary residence, those years are not considered non-qualified use. For instance, if a homeowner rented out a property for three years, then lived in it for two before selling, the prior rental period would not reduce the exclusion. However, this does not eliminate other tax consequences, such as depreciation recapture.

Depreciation Recapture

When a home has been used as a rental, the IRS requires sellers to account for depreciation deductions claimed during the rental period. Depreciation allows property owners to reduce taxable rental income by deducting a portion of the home’s value each year, based on a 27.5-year recovery period for residential rental property under IRS MACRS rules. While this provides tax benefits during ownership, it creates a future tax liability when the property is sold.

Upon sale, the IRS mandates depreciation recapture, meaning any depreciation previously deducted must be repaid as taxable income. This recaptured amount is taxed as unrecaptured Section 1250 gain at a maximum federal rate of 25%, rather than the standard long-term capital gains rate of 0%, 15%, or 20%.

For example, if a homeowner rented out a property for four years and claimed $20,000 in depreciation, that full amount must be reported as taxable income upon sale. Even if the overall gain qualifies for exclusion, the IRS still requires the recapture tax to be paid. Additionally, state taxes may apply, with rates varying by jurisdiction. Some states fully conform to federal depreciation recapture rules, while others impose different tax treatments.

Allocation for Mixed-Use Properties

When a property has been both a primary residence and a rental, gains must be allocated between personal and business use. Only the portion of the gain related to the time the home was a primary residence qualifies for exclusion, while the portion tied to rental use remains taxable.

A common approach is time-based proration. For example, if a homeowner owned a property for 10 years, lived in it for six, and rented it for four, 60% of the gain could qualify for exclusion, while 40% would be taxable. The IRS may also consider a square footage-based allocation if only part of the home was rented, such as a duplex or a home with an accessory dwelling unit (ADU). In these cases, the gain must be apportioned based on the percentage of the property used for business purposes.

Reporting the Sale

When selling a home that was previously used as a rental, the transaction must be properly reported to the IRS. The sale is typically documented on Form 8949, Sales and Other Dispositions of Capital Assets, and summarized on Schedule D (Form 1040), Capital Gains and Losses. If depreciation was claimed during the rental period, Form 4797, Sales of Business Property, must also be completed to account for depreciation recapture.

The adjusted basis of the property plays a significant role in determining taxable gain. This is calculated by taking the original purchase price, adding capital improvements, and subtracting depreciation deductions.

For example, if a home was purchased for $300,000, had $50,000 in improvements, and $30,000 in depreciation, the adjusted basis would be $320,000. If the home sells for $500,000, the total gain is $180,000, but only the portion related to rental use and depreciation recapture is taxable.

Proper documentation is essential to support reported figures. Settlement statements, depreciation schedules, and records of improvements should be retained in case of an IRS audit. Additionally, state tax reporting requirements may differ, with some states requiring separate forms for depreciation recapture or proration of gains. Taxpayers should review their state’s specific rules to ensure compliance and avoid unexpected liabilities.