The “2-out-of-5-years rule” is a rule related to the criteria that must be met in order for a property investor to avoid or reduce capital gains tax owed upon the sale of their property.
Avoiding Capital Gains Tax
To understand the 2-out-of-5-years rule, you need to understand the desire for property owners to avoid or reduce taxes owed when they sell a property.
To avoid paying more than they have to in taxes, many property investors take advantage of opportunities such as the 1031 exchange process or “home sale exclusion” tax breaks. The 2-out-of-5-years rule is one of the criteria that must be met in order to qualify for the home sale exclusion.
When selling a primary residence property, capital gains from the sale can be deducted from the seller’s owed taxes if the seller has lived in the property themselves for at least 2 of the previous 5 years leading up to the sale.
That is the 2-out-of-5-years rule, in short. But, there are some important details to keep in mind, so keep reading!
Primary Residence vs Investment Property
The reason the 2-out-of-5-years rule exists is because the home sale exclusion tax break is only applicable to the sale of a primary residence. In order to be legally considered a primary residence, as opposed to an investment property, is that the seller has lived in the property themselves for at least two out of the last five years.
Do the 2 years need to be consecutive?
The two years of on-site residency do not need to be consecutive. For example, a property owner might live in a house for a year, then move and rent it out for 3 years, then move back in for another year before selling; the property would still qualify as a primary residence.
The seller does not need to be living in the property at the time of sale in order to claim the home sale exclusion. They just need to have lived there for a minimum of two out of the last 5 years.
How much capital gains tax can I exclude?
The amount of capital gains that can be excluded is dependent on your tax filing status.
For those filing single, up to $250,000 in capital gains can be excluded. For those filing jointly, the limit is $500,000.
What about vacation rental property?
According to the 2-out-of-5-years rule, property that you lived in for at least two out of the last five years counts as a primary residence, even if you have considered it a vacation rental.
In order to be a true vacation rental property and not a primary residence, according to the tax code, the property would have to be rented out/not lived in by the owner for more than two of the previous five years.
How often can I claim the home sale exclusion tax break?
While there is technically no limit to how often the home sale exclusion can be claimed (every time a home is sold), the qualification of having lived in a property for at least two out of the last five years means that an individual couldn’t claim the tax break more than once every 2 years.
Exceptions to the rule
In this guide, we have outlined the basic features and requirements of the 2-out-of-5-years rule, but there are some exceptions to the rule in special circ*mstances.
Toward the end of this blog post by Clay Schmidt at Realized, he lays out some of the special situations in which some capital gains might still be excludable even if the 2-out-of-5-years rule isn’t exactly met the way we’ve outlined it in this guide.
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