Does Renting My Home for Two Months Kill the $500,000 Exclusion?
Exclusion Rule
The tax code allows you to exclude from gross income up to $500,000 of gain (joint return, $250,000 if single) from the sale or exchange of your home if
during the five-year period ending on the date of the sale or exchange
such property has been owned by you or your spouse for periods aggregating two years or more and
used by both you and your spouse as your principal residence for periods aggregating two years or more.
Planning note. The ownership and use periods do not have to be the same.
Background for Question
We live in an area with high summer-season demand. We are thinking of renting our home during the summer while we go on an extended vacation (perhaps several weeks).
Our home is worth significantly more than what we paid for it. We want to be sure the gain can qualify for the $500,000 tax-free exclusion, as we are thinking about selling the home in the near future. We are concerned that renting the home for more than 14 days during the year might compromise the gain exclusion.
I noodled around on the internet and found this regarding the gain exclusion, but I am unclear about the interpretation:
In establishing whether a taxpayer has satisfied the two-year use requirement, occupancy of the residence is required. However, short temporary absences, such as for vacation or other seasonal absence (although accompanied with rental of the residence), are counted as periods of use.
The “although” in the above text is particularly confusing to me.
Question
Do I need to be concerned about how many days we rent our primary residence in a given year for fear of losing all or part of the home-sale-gain exclusion?
Answer
First, congratulations on finding the IRS regulation that applies to your desired actions. We admit that the regulation you found could be clearer.
And further down in the regulations, the IRS provides more clarity. Here’s what the IRS said in an example that fits your desired vacation activity:
Taxpayer E purchases a house on February 1, 1998, that he uses as his principal residence. During 1998 and 1999, E leaves his residence for a two-month summer vacation.
E sells the house on March 1, 2000.
Although, in the five-year period preceding the date of sale, the total time E used his residence is less than two years (21 months), the section 121 exclusion will apply to the gain from the sale of the residence because, under paragraph (c)(2) of this section, the two-month vacations are short temporary absences and are counted as periods of use in determining whether E used the residence for the requisite period.
To summarize, E was living in the house for 21 months and on vacation for four months, giving him a total of 25 months. To take advantage of the $500,000 home-sale exclusion, E had to use the home for 24 months or more. The IRS says he meets the 24-month rule because his vacation time counts as use of the home as a home.
Rental
The IRS states that the rule above applies even if you rent the home while you are on vacation. So, no problem there.
You were concerned about the 14-day rule, which comes from the vacation-home rules. Here’s how the vacation-home rules work for you.
Your home is going to be a home under the vacation-home rules when you use it as your home for a number of days that exceeds the greater of
14 days, or
10 percent of the number of days during such year for which such unit is rented at a fair rental.
Example. You rent the home for 60 days and live in it for 305 days. Your home is a home under the vacation-home rules because your personal use is greater than 14 days and greater than six days (60 x 10 percent).
At the end of the year, you need to tally the rents you received and allocate the home expenses to the rental based on the ratio of rental days to personal days. On page 20 of IRS Publication 527, you will find a handy worksheet for figuring the home deductions that you can use against the rental income.
If you have a tax loss on the rental part, it’s not deductible against other income, but all is not lost. The law allows you to carry over any losses to the next tax year, when they again become available against your home-rental activity.
Takeaways
The home-sale exclusion of $500,000 ($250,000 if single) of taxable gain when selling your home is a valuable tax break.
It’s good to know that when you leave home for a two-month vacation you do not impair your required two of five years of use. Not only that, but the IRS in its regulations allows you to rent your home while on this two-month vacation.
At the end of the year, you tally the rental income and deduct the expenses using an IRS worksheet that makes the process straightforward. If the worksheet shows that the rental lost money, you can’t deduct the loss. Instead, you carry it over to the next year, when you again apply it against the rental income.