Real Estate Tax Breaks: The 2-Out-of-5 Rule

When selling your primary residence, understanding capital gains is crucial. If you have owned the home for at least two years and lived in it for at least two out of the five years before the sale, you may be eligible for certain tax benefits. This is the “2 out of 5-year rule.”

The “2 out of 5-year rule” is a term commonly associated with Section 121 of the Internal Revenue Code. It may let you exclude a portion of the gain when you sell your primary home, as long as you meet the ownership and use tests.

How do you qualify for a capital gains tax exclusion under Section 121?

• Primary Residence Requirement: To qualify for the capital gains tax exclusion under Section 121, the sold property must have been your primary residence. This means the place you primarily lived, rather than a vacation home or investment property.
• Ownership Requirement: You must have owned the property for at least two years during the five years ending on the date of the sale. That is at least 24 months of ownership within the 5 years before closing.
• Residence Requirement: Additionally, you must have used the property as your primary residence for at least two years (24 months) during the same five-year period. These months do not have to be consecutive. This requirement ensures that the property was, in fact, your main home.

If you qualify, the Section 121 home sale exclusion allows homeowners to exclude a portion of their capital gains from the sale of their primary residence. The exclusion amount is up to $250,000 for individuals and $500,000 for married couples filing jointly. Taking advantage of this exclusion can meaningfully reduce your tax bill when you sell.

Limitations and exceptions to the 2-out-of-5 rule

• Frequency of Exclusion: The capital gains tax exclusion for the sale of a primary residence can typically be claimed once every two years. This means that if you claimed it on a sale, you generally need to wait two years before claiming it again.
• Maximum Exclusion Amounts: The maximum amount of capital gains that can be excluded from taxable income is $250,000 for single filers and $500,000 for married couples filing jointly. These limits apply to your net gain on the sale.
• Ownership and Residence Requirements: As previously mentioned, to qualify for the exclusion, you must have owned and lived in the property as your primary residence for at least two years out of the five years leading up to the sale. If you fail to meet these requirements, you may not be eligible for the exclusion.
• Partial Exclusions: In some instances, you may be eligible for a partial exclusion if you do not meet the ownership and residence requirements due to unforeseen circumstances such as a change in employment, health reasons, or other qualifying factors. The amount of the partial exclusion is prorated based on the time you owned and lived in the home.

Unique considerations for the 2-out-of-5 rule: Divorce and military personnel

When it comes to primary residence capital gains, special situations like divorce and military service can introduce unique considerations and tax implications.

When you sell a primary residence as part of a divorce settlement, it’s essential to understand the impact on capital gains. Generally, married couples can exclude up to $500,000 in capital gains from the sale of their primary residence, while single individuals can exclude up to $250,000. However, in a divorce, the exclusion amount may change depending on the individual circumstances.

Military personnel face unique considerations when it comes to capital gains on primary residences. The Internal Revenue Service (IRS) provides special rules for members of the military who are required to move due to their service. Under Section 121, qualified extended duty can “suspend” the five-year clock for up to 10 years, which may help you meet the tests. Separately, programs like the former Military Homeowners Assistance Program (HAP) and PCS moves can affect timing and eligibility. Military personnel must understand these rules and take advantage of any available benefits to minimize their tax liability.

In addition to divorce and military service, other special situations may also have unique tax implications for primary residence sales. For example, if you’re selling a primary residence that was previously a rental or vacation home, different rules may apply. Depreciation taken while the house was a rental is generally subject to recapture, and periods of “nonqualified use” can reduce the amount of gain eligible for the exclusion.

Seeking professional guidance

When it comes to navigating the complex world of primary residence capital gains, seeking professional guidance can make all the difference. Consulting with a knowledgeable tax advisor is the best way to ensure you are well-informed about the tax implications associated with selling your primary residence. If you’re considering a sale in the next one to two years, start the conversation early so you can document eligibility and optimize timing.

This content is for informational and educational purposes only and should not be construed as individualized advice or a recommendation for any specific product, strategy, or course of action. Brighton Jones, its affiliates, and employees do not provide personalized investment, financial, tax, or legal advice through this communication. This material is not intended to, and does not, create a fiduciary relationship under ERISA or any other applicable law. For individualized advice tailored to your specific circumstances, please consult with your adviser.