Renting a property does not avoid capital gains tax, no matter how long you rent it. The opposite sometimes applies; if you don’t personally live in your home, you'll probably owe capital gains tax when you sell it. The IRS levies capital gains taxes on investment properties, and when you move out of your home to rent it, it usually becomes an investment property.
Nature of Tax
If you live in your home, then move out and rent it to a tenant after you go, the IRS usually charges 15 percent of your profit in capital gains taxes if you were to sell the property. For example, if you purchase a home for $150,000, then move out and rent it for three years, then finally sell it for $200,000, you could owe $7,500 in capital gains tax (15 percent of $50,000). But there are exceptions.
Capital gains tax once applied to all properties bought and sold for a profit. In 1997, the Taxpayer Relief Act changed that. Now profits from the purchase and sale of a home you live in are exempt up to $250,000, and double that if you’re married and file a joint return. The catch is that you must own the property for five years and you must have resided in it for two of those years. So if you owned your house for four years and rented it out for three of those years, you would not qualify for this exemption. If you owned it for five years and rented it out for three years, and if you personally lived in it the other two years, you would not owe capital gains tax.
If you don't meet the residency qualifications, you might still be able to avoid capital gains tax if you immediately reinvest the profits from the sale of your home. Under Section 1031 of the tax code, if the proceeds of your house sale never touch your bank account, they become tax-exempt if you use the money to purchase another home within six months. A 1031 exchange is an intricate process that requires the use of a disinterested third party called an accommodator, who takes in the money for the sale and reinvests it for you, so there's no chance it can be construed as income to you. If you want to make use of this option, speak with a tax or real estate professional, as the procedure can be complicated.
Your two-year residency in the home does not have to be continuous. If you've owned your home for four years, lived in it the first year, then moved out and rented it, you can move back into it for a year, then sell it. This would exempt it from capital gains taxes.
If you wind up having to pay capital gains tax, the taxable portion is not necessarily the difference between what you purchased it for and what you sell it for. You can deduct some of the costs of the sale from your profits, such as realtor commissions, legal fees and any points you paid to the mortgage company when you purchased it.
Beverly Bird has been writing professionally for over 30 years. She is also a paralegal, specializing in areas of personal finance, bankruptcy and estate law. She writes as the tax expert for The Balance.