What Is the 2-Out-of-5-Year Rule?

When you think about it, 20 % of the sale value is a huge amount to just hand over to the IRS. Fortunately, you may be partially or wholly exempt from this tax law, and you could end up keeping most, if not all, of your sales.

This is thanks to the 2-out-of-5-year rule. What exactly does the rule say, and do you meet the legibility criteria? Read on to learn more on how to keep more money in your pocket from your primary property sale, thanks to the 2-out-of-5-year rule.

What is the 2-out-of-5-year rule?

This rule stipulates that you can exclude up to $250k from the sale of your main home or up to $500k if you're married. The main requirement for this exclusion is you should have owned and lived on the premises for at least two years. This number is calculated from 5 years before you want to sell the property.

Fortunately, there are quite a several ways to get around this number. For starters, the two years don't necessarily have to be consecutive. Moreover, you can use this rule once every two years to exclude any profits made from the sale of the house.

What type of home does the rule apply to?

Real estate law is usually very specific, and getting to the details can often mean the difference. Luckily, this law applies to all types of houses. It does not matter if you own a townhouse, trailer, condo, houseboat, corporative apartment, or single-family home. The major determinant to this rule is whether you've been physically living on the premises or not.

This also means that you can't avoid taxation from the sale of a second home aided by this rule. Additionally, other property types, like rental units, are not covered by the rule as you are not living on the premises. However, if you are on a long-term vacation or rent your primary residence for some time, you are still covered by the 2-out-of-5-year rule.

Buying another home cannot help you avoid the capital gains tax at the federal level. However, buying a second home can exempt you from local and state tax liabilities in some municipalities and states.

Traditionally, there was a rule where you didn't have to pay capital gains tax if you sold your primary residence and were over the age of 55. However, this law was repealed in 1997 and replaced by the current section 121 home sale tax exclusion.

How much money can you exclude with this rule?

As previously mentioned, the subject rule allows you to exclude a maximum of $500,000 if married or $250,000 if you're single. If the house sale is lower than these amounts, the money excluded will obviously be lower as it is limited to your actual gains.

Some people try and cheat the system altogether by selling the property to a family member for an insanely low amount. For example, a parent could sell the primary property to their child for $1. However, there are legal measures to keep such occurrences from happening.

In this example, you will not pay capital gains tax when you sell the property for less than its market value. Nonetheless, you won't really avoid paying tax as you still have to pay federal gift taxes. Federal gift taxes are calculated by finding the difference between the actual value of the property and the sale value. And since federal gift tax is higher than sale capital gain tax, you'll end up paying more than you would have originally.

How do you report the gains?

Profits from the sale of your primary property should be reported on Schedule D as a capital gain. This should be done if you don't qualify for the exclusion or make a profit that exceeds the exclusion amount.

If you owned the property for less than one year, it should be reported as a short-term capital gain as opposed to a long-term capital gain if you had the property in your ownership for more than a year.

The taxes from a short-term capital gain are calculated at the same rate as your regular income and according to your corresponding tax bracket. On the flip side, long-term gains are more favorable as the amount is calculated at either 0%, 15%, or 20%, depending on the taxable income amount.

Ultimately, there are a lot of factors to consider when using the 2-out-of-5-year rule. The most important thing is to keep accurate records to serve as proof if necessary. Lacking the proper documents will not necessarily exclude you from the rule, but it will complicate the process and make it even more arduous.