Mike has a residence and a rental property. Both have substantially appreciated in value. Mike sells her primary residence, takes her capital gain exclusion of up to $250,000 on that residence, and decides to move into the rental unit. The rental unit now becomes her primary residence.

Mike resides in the rental unit for another two years to qualify for the ownership and use tests. Mike then sells the property and realizes a substantial gain... of which up to $250,000 can be excluded under the law. Poof... gone.

It makes no difference that most of the appreciation on the second property was realized when it was a rental unit. It also makes no difference that much of the taxable gain is attributable to depreciation that Mike claimed as a deduction against the property in prior years. Mike met all of the tests to exclude the gain and is therefore eligible to do so. Mike has used the tax laws to her advantage. She planned her life to rid herself of some substantial taxes. Nothing illegal or immoral about that.

A Word on Depreciation

It should be noted that all of Mikes gain might not be excluded. Why? Because depreciation taken on the rental property after May 6, 1997 will be subject to "recapture" and tax. But only the depreciation taken after May 6, 1997 will be subject to recapture. Any depreciation taken before that date will be "forgiven" and will be available for the gain exclusion.

Even with this minor inconvenience of recognizing gain on the depreciation claimed after May 6, 1997, the conversion of a rental property to a primary residence likely still makes sense from a tax standpoint. Heck, it seems like a very small price to pay to exclude up to $250,000 (or $500,000 on a married/joint return) of gain.