It looks like FS scenario #2 is wrong. Bob didn't shoot himself in the foot, after all.
"Eligibility Step 1—Automatic Disqualification" -- Bob's ok there
"Eligibility Step 2—Ownership" -- Bob's definitely the owner for 24 months.
"Eligibility Step 3—Residence" -- This is the tricky one, discussed below.
"Eligibility Step 4—Look-Back" -- Has Bob used the exclusion in the past 2 years? No, he hasn't.
"Eligibility Step 5—Exceptions to the Eligibility Test" -- No exceptions for Bob.
"
Eligibility Step 3—Residence", explained
If you owned the home and used it as your residence for at least 24 months of the previous 5 years, you meet the residence requirement. The 24 months of residence can fall anywhere within the 5-year period, and it doesn'tt have to be a single block of time. All that is required is a total of 24 months (730 days) of residence during the 5-year period.
Compare that eligibility rule with the FS scenario:
Bob bought his house in 2003 and moved in right away. He lived there until January 1, 2016, and started renting it out after that. But it’s mid-2018, and he’s worried he might not be able to sell it before January 1, 2019. So, to make sure he doesn’t fall short of the 2-out-of-5-years rule, he kicks his tenant out and moves back into the property on July 1, 2018.
In the previous 5 years, from 7/1/13 to 7/1/18, Bob lived in the house for 2.5 years (from 7/1/13 to 1/1/16). That meets the 24 month test, as FS notes, giving Bob until 1/1/19 to sell it and get the exclusion (1/1/14-1/1/16).
However, if the house is sold on 3/1/19, Bob still meets the 24 month test (3/1/14-1/1/16 + 7/1/18-3/1/19) and gets the full exclusion if he moved back in. The FS conclusion contradicts this:
If Bob continues to live in his old rental, then his prorated capital gains inclusion will continue to grow, but never back to 100%. For example, if he lived in the property until Jan 1, 2022 (for three more years) after moving in on July 1, 2018, his exclusion would be 16.5 / 19 years, or 87%.
If the eligibility requirements are met, then Worksheet 1 is used:
https://www.irs.gov/publications/p523#en_US_2017_publink100077247"You are eligible for the maximum exclusion if..."
"Both spouses meet the residence and look-back requirements and one or both spouses meet the ownership requirement."
Following the steps in 1.B) also agree with this (because the smallest period is 24 months, and its divided by 24 months, yielding 1 * $250k).
I think the confusion lies in the code, 121(a), "...for periods
aggregating 2 years or more." Because the residence periods don't have to be contiguous, an owner can move back in at any time to reach 24 months.