Q: I’ve often read that to avoid paying capital gains tax on a home, you should purchase a home as a rental investment, let the tenant pay off the loan, and then move into the home at least two years before you intend to sell it. That way, you can keep the profits without paying tax.

Here are my questions. If an owner lives in the house for the first two years of a five year period, could the property be rented out for the last three years or vice-versa?

Also, if there is $150,000 appreciation in the property and the owner has depreciated the property by $100,000, does the appreciation and depreciation of $250,000 qualify for the $250,000 capital gains tax exemption, allowing the owner to sell the property without paying any taxes?

A. This question is better suited for a tax accountant and you should seek his or her advice for further information.

In general, however, if you live in a property for two out of the prior five years (the order of when you’ve lived there is not important), and the property was your primary residence for two years, you are entitled to exclude $250,000 of the gain in the sale of the home from any taxes.

The key to your question is what would constitute the “basis” of your home. In simple terms, the “basis” of a home for most buyers is what they paid for their home plus certain purchase expenses plus major improvements. The basis can be reduced by any benefits you have received such as depreciation or insurance payments for a casualty. The Internal Revenue Service has a publication that furnishes examples of how to compute the basis of a home and how to compute the taxes you will owe on the sale of a home.

In your case the IRS publication indicates that the depreciation would adjust your basis. In addition, you would only pay taxes on the gain above and beyond the $250,000 exclusion. Your circumstances indicate that your basis would be reduced by $100,000 and your gain would be $150,000. The combined amount is $250,000 and within the exclusion amount. Therefore you probably will not have to pay a tax on the sale of the home.

You may wish to review Publication 523 on the Internal Revenue Service web site at WWW.IRS.Gov for more information.

Published: Jan 9, 2004