We have a question about the capital gains tax exemption for selling a house.?

Question

We had been in a house for 10 years. Last May we put it on the market to sell and moved into a rental house we own. The housing market is bad so we are just now selling our old house over a year later. The law as we understand it is that we are exempt from paying cap. gains tax if the house was our main residence 24 out of the last 60 months. We qualify for that on the house we just sold but our question is does the time we've been living in the other house count toward having it as our main residence and could we sell it once the 24 months is up and also get the same exemption? If we do that we will be submitting for the exemption two tax years in a row so it might look a little fishy, but technically we will have had both houses as our main residence for 24 out of the past 60 months, it's just that the first one sat empty for more than a year while we lived in the other.

Answer 1

No, you can only take the exemption if you didn't exclude gain on another home within the 2 year period ending on the date of the sale of the second house, so you'd have to wait longer before selling the second one if you want to exclude the gain on that one.

Answer 2

Actually, the exclusion cannot be used again for two more years.  In the current market, are you sure you will have a gain?  Selling a house that has been used as a rental is a little more complicated, since you have to factor in depreciation, so there is more likelihood of a gain.  One possibility:  if the gain on the first house is minimal, go ahead and pay the cap gains tax, and use the exclusion for the second house once you meet the qualifying time of residence.  

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Answer 3

You can only have one principal residence at any time.  When you moved into your rental house, it became your principal residence.

Your house that you sold qualifies for the capital gains exemption, as you noted.  You also have 12 months of time lived in the rental house.

Besides the criteria you mentioned to qualify for the capital gains exclusion, you cannot exclude the gain on the sale of a home if during the two-year period ending on the date of the sale, you sold another home and excluded all or part of the gain.  See IRS Pub 523.

So you will have to wait 2 years from the date of the sale of your first home to qualify for an exclusion for the second home.  The rules make it impossible to take the exclusion two years in a row.

Since the second home is converted from your rental property, your exclusion will be reduced by the amount of depreciation you took or were allowed to take on the rental property.  

If you aquired your rental through an exchange with another business property, there are yet more restrictions which you should consult a tax person about if this applies to you.