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Originally Posted by DDDDave
If she has been depreciating the rental property she will also have to pay 'depreciation recapture' tax. She will definitely want to talk to her accountant. As long as she knows her 'stepped up basis', the tax due on sale is not that hard to calculate.
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Yeah, if you're not ready for that, it'll slip up behind you and slap you a good one. Happened to me once. Back when I had rental property I had a talk with an accountant about all this, and it's like what's been said: you have to live in the house you're selling for a couple of years before you can sell as a residence and claim the exemption. If she wanted to move into the rental and sell her current house, it would work for her. But not otherwise.
I've just heard -- on the radio, so double-check -- that there can be some ifs, ands, and buts about the two-year residency rule. Like, it just has to be two years residency out of the last five, and not necessarily sequential. But I don't think that'd help in this case, even if I did hear it right.
And as DDDave says, capital gains tax is now 15 percent, an historic low. So the pain is minimized. I can practically guarantee that the capital gains tax won't stay that low for very many more years, so now is the time to realize gains.
Just an aside: some people really make the residential exemption thing worked for them. My accountant told me about a couple that owned their own home and a rental. They wanted to build their dream home. So they sold their principal residence, moved into the rental, used the tax-free proceeds to start planning and building their house; and, when it was ready after a couple of years, sold the _rental_ tax-free and moved into the dream home. Used the proceeds to mop up existing debt and put the rest in the bank as a nest egg. All tax free. Like I said, if you can do such things, now is the time. Doubt it'll last.