[quote=SD Realtor]Yeah that 2 out of 5 years exclusion is nice. Even if you pass that exclusion though, if you have cap losses you are carrying forward from perhaps stocks or something, if you sell the home as a purely income property you can line that gain up against those losses..[/quote]

Is that really true? I have been told that operating losses in a year are considered passive activity and can not be used to reduce taxable income or investment income. Not sure about cap gains though.

If it is true, what is the basis for capital gain? The original purchase price or market value at the time when it turns into a rental?