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To take advantage of the exclusion for sales and exchanges, you must have owned and used the home as a principal residence for at least two of the five preceding years. The two years for each test need not have occurred at the same time.
In tallying up the time periods, you can count short periods of absence for vacation, seasonal absences, or any other temporary absence (generally, anything under one year) as time that you spent using the home.
Also, there are some grandfathering provisions in the law, which say that if you previously owned a home and rolled over the capital gains from that home into your current home under the old rollover-replacement rule, you can count the time you owned and/or lived in that previous home toward your two-year period. To take advantage of this exception, you can't have sold another home within two years of your sale, or since May 7, 1997 (whichever period is shorter). This is true even if your previous home was condemned or destroyed.
If you can't meet the two-year rules because you became physically or mentally incapable of self-care, you qualify for the exemption if you owned and lived in the home for at least one year.
In a new twist to these rules, the American Jobs Creation Act of 2004 requires that a principal residence be owned for at least five years prior to a tax-free sale or exchange if the residence was acquired in a like-kind exchange.
This change applies to sales or exchanges occurring after October 22, 2004. However, the two-year ownership rule still applies for other types of acquisitions (e.g., purchasing a residence). Also, in any case, the two-year period of use as a principal residence remains unchanged.