Rented your home out? Two rules, not one

Plenty of writing on this says that renting your home out costs you part of the home-sale exclusion. That is true in one direction and generally false in the other, and which one you are in depends on the order of events rather than on whether you rented at all.

There are two separate rules here. People tend to merge them, which is how both the alarm and the false reassurance get produced.

Two rules, not one

Depreciation recapture applies to depreciation allowed or allowable after 6 May 1997. It sits outside the exclusion entirely, is taxed at up to 25%, and it does not care about the order of events. Rent the place at any point and this is in play.

Non-qualified use is the other one. Broadly, periods after 2008 when the property was not your principal residence reduce the proportion of gain you may exclude (Publication 523). This one cares about the order a great deal.

If you rented after moving out

This is the common case: you lived there, you moved, you let it out rather than selling into a bad market, and you sold later.

The statute excludes from non-qualified use any portion of the five-year period which is after the last date the property was used as the principal residence (26 U.S.C. § 121(b)(5)(C)(ii)). So that rental period generally does not reduce your exclusion.

This is the part most summaries get wrong, in the direction that worries people unnecessarily. Renting after you move out is not, by itself, a haircut on your exclusion. Depreciation recapture still applies — but that is a different and smaller thing than losing a share of $250,000.

Two other exceptions are worth knowing: certain periods of qualified official extended duty for military, Foreign Service and intelligence personnel, up to ten years in total; and other temporary absences of up to two years in aggregate for a change of employment, health, or unforeseen circumstances.

If you rented before moving in

Now reverse it. You bought the property as a rental, let it for some years, then moved in and made it your home, and later sold.

Those earlier rental years fall before your last use as a principal residence, so the exception above does not reach them. Where they fall after 2008 they are non-qualified use, and the excludable gain is reduced roughly in proportion to that time against your total ownership period.

This is the case that genuinely costs you, and it is the one people rarely read about — partly because “converting a rental into a home” sounds like the sympathetic direction of travel. Depreciation recapture applies here as well, on top.

The trap that catches people anyway

There is a simpler way to lose the exclusion that has nothing to do with non-qualified use: the use test.

You must have lived in the home as your main residence for at least 24 months of the five years ending on the sale date. Move out, rent it for more than three years, and you no longer meet that — so the exclusion is gone entirely, not merely reduced.

The clock, not the rental, is what does it. Someone weighing whether to keep letting a former home for another year is making a decision with a deadline attached, and it is worth knowing that before the deadline rather than after.

What decides it is records

Every rule above turns on facts about dates and amounts:

• The exact dates it was your principal residence, and the exact dates it was let
• The depreciation schedule for each rental period — what was taken, and what was allowable
• Improvements, and when they were made, since work done during a rental period is treated differently from work done while you lived there
• The original purchase documents, which set where all of it starts

Qualifying improvements may raise your adjusted basis and reduce taxable gain, but only where you can support the cost. In a property with a mixed history, the dates matter as much as the amounts — and the dates are the thing nobody writes down at the time.

How depreciation recapture works covers the first of the two rules in full.