The days when you could convert your rental property or vacation home to a principal residence and then use the full $250,000/$500,000 home-sale exclusion to avoid taxes are gone.
Here’s how the $250,000/$500,000 exclusion works today. You must divide your period of home ownership into two categories—qualified and nonqualified use:
Qualified use means the time you or your spouse use the home as your principal residence. Nonqualified use means anytime January 1, 2009, or later in which neither you nor your spouse (or your former spouse) uses the property as a primary residence.
You allocate gain on the sale of your home between the periods of qualified and nonqualified use, and the gain allocated to nonqualified use doesn’t qualify for the $250,000/$500,000 home-sale exclusion. For example, if you owned the property for eight years, lived in it for the last two years, and rented it out for six years, it served as an investment property 75 percent of the time. Therefore, you can exclude 25 percent of your gain from taxation.
You have one important exception to the nonqualified use definition: nonqualified use does not include rental use during the five-year period that’s after the last date you or your spouse used the property as your principal residence.
In other words, if you live in your principal residence for two years and then rent it out for three years or less, the rental period is not a “period of nonqualified use,” and you qualify for the full $250,000/$500,000 home-sale exclusion.