Such accidental landlords should understand that if they rent out their homes too long before they sell them, they could lose the biggest tax break available for most people: the home sale exclusion.
Homeowners who qualify for the home sale exclusion don't have to pay any income tax on up to $250,000 of the gain from the sale if they're single, or up to $500,000 if they're married and file a joint return. Of course, this exclusion is useful only for homeowners who have equity in their homes, not the millions who are "under water" and will receive no profit if they sell their homes.
To qualify for the exclusion, a homeowner must satisfy the ownership and use tests. This means that during the 5-year period ending on the date of the sale, the homeowner must have:
- owned the home for at least 2 years (the ownership test), and
- lived in the home as a primary residence for at least 2 years (the use test).
This means that a homeowner can move out of the house for up to three years and still qualify for the exclusion. Moreover, a homeowner can rent out a home and count that time as ownership time.
This rule has a very practical application: A homeowner may rent out a home for up to three years prior to the sale and still qualify for the exclusion. However, the exclusion works a bit different for homeowners who have rented out their homes.
They cannot exclude from their income the part of their gain equal to the depreciation they claimed (or could have claimed) while renting the home. Moreover, if the home is rental property at the time of the sale, the sale must be reported to the Internal Revenue Service on Form 4797: Sales of Business Property.