Note: This is not professional tax advice. While I have confirmed this information with various professionals, do not take my word for it. Read the tax rules yourself (link at the bottom.) Then, consult with your tax professional to see how the rules apply to you.
Capital Gains? What the heck are they, and when do you pay them? When you’re in the military, one of the most confusing parts about being a homeowner is understanding when you’ll be subject to capital gains taxes on the sale of that property. The capital gains rules for military families have a special set of rules. You need to know them!
Capital Gains Tax and Exclusion
When you buy a house, and later sell it, the profit is subject to capital gains taxes. There is a generous tax break available to everyone: if you live in the house for two of the five years prior to the sale, you can exclude up to $250,000 ($500,000 for a married couple) in profits from taxation. The two of five years rule is often called the “use test,” as it is establishing whether you used the property as your principal residence. (Technically, it is counted in days. Just FYI.)
For example, Joe and Sally buy a house in June 2010, and live in it until December 2013. They then move into a new house and rent out their old house. In September 2016, they sell the rental house. By counting back five years from the date of sale (September 2011), you can see that Joe and Sally lived in the house for more than two years (September 2011 to December 2013) of the five years prior to the sale. They are able to exclude up to $500,000 in profits from being subject to capital gains taxes.
As another example, Erin and Paul buy a new house in December 2014. In December 2015, they have triplets, so they sell their house to purchase a larger house. Because Erin and Paul did not live in the house for two years, they are subject to taxation on any profit from the sale. (Depending on the details, Erin and Paul may be able to take a pro-rated exemption and not pay the full amount of taxes.)
You generally can not take the capital gains exemption more than once every twenty-four months. There are some very specific situations where it may be possible. You’re going to want to read about them specifically in section121(b)(3)and then sections 121(c)1 and (c)2. https://www.law.cornell.edu/uscode/text/26/121 It’s worth repeating here: You need a tax professional who really, really gets capital gains and the military rules. Click To Tweet
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Suspension of Time for Military
If you are military on active duty and receive (PCS) orders more than 50 miles away from the property, you may “suspend” the clock on the two-out-of-five rule listed above. The suspension may last no more than ten years, for a total lookback period of 15 years.
For example, Tom and Jennifer buy a house 2005, and live in it until 2010. They receive PCS orders across the country, and make their house a rental. In 2015, they decide to sell the property. They are eligible to exempt their profits by suspending the years 2013 to 2015. Then, they qualify by showing that they lived in the house for two of the five years prior to the suspension (2008 to 2010.)
To shorten the math: Military families may be able to exempt profits from capital gains if they lived in a house for two of the fifteen years before the sale, as long as they were not stationed within 50 miles of the property at any time of non-residence, and considering the following important detail:
Multiple Properties
It is very important to note that you can not suspend the time for more than one property at a time.
For example, let’s say that Matt and Melissa buy a house in Virginia in 2003 and live in it until 2007. They receive PCS orders to move to Florida. They rent out their house in Virginia, and buy a house in Florida. In 2010, they receive PCS orders to California. They rent out their Florida house and now have two rental properties.
In 2016, they decide that they are tired of being landlords and sell both houses. They have not lived in either house for two out of the last five years, so they are not eligible for the regular tax exclusion on either property. However, they are eligible to suspend the clock on ONE of their properties. They will have to figure out which property will get the most benefit from the suspension, and pay full capital gains taxes on the other property.
The Tax Is Only On The Profit
Don’t forget that the capital gains tax is only paid on the net profit made from the property. Net profit will include the original purchase price, plus capital improvements, selling costs, and selected purchasing costs. Great record-keeping pays off when you are calculating your gain.
We’ll Just Move Back In!
Prior to 2009, you could reset that 2-out-of-5 clock by moving back into the property. This is no longer true. A full explanation of this rule is well beyond the scope of this article, but be aware that re-occupying the property for 2 years will not erase the years of rental use. Your specific situation will depend on your unique details. You need to meet with a tax professional who thoroughly understands the military suspension and the qualified use rules. Do this before you make the decision to move back into a house that has been a rental. It may be a bad idea for your situation. Here’s an article that will give you a brief overview of the rules: https://www.merriman.com/wealth-preservation/planning-on-moving-back-into-your-rental-in-the-future-read-this-first/
Selling After Leaving The Military
While you can’t exempt/suspend time that happens after you leave military service, there are still 3 years remaining out of that 2-out-of-5 rule. This may mean that you can sell after separating from the service and still benefit from this rule.You will need to talk to your tax professional and see where you stand on this subject.
Depreciation Recapture
It is important to note that at the time of sale, you will also be subject to the “recapture” of the depreciation taken on the property over the years it was a rental. This is somewhat complicated. I strongly recommend that you get a qualified tax professional to handle the math. If you’re looking for a broad general rule, you should expect to pay up to 25% of the amount you have depreciated over the years.
There are various things you can do that may reduce the tax liability on the sale of a rental property, including deferring the taxes by purchasing another property in a 1031 tax-deferred exchange, or by living in the house for a period of time before selling. There are tons of resources available to explain these options, if you are interested.
The application of the military suspension for the calculation of the use test is very misunderstood. I have seen many people claim that it means that you have to live in the house for two out of ten years, or other misinterpretations of the law. You can find the exact explanationand example in IRS Publication 523, Selling Your Home. The examples in Pub 523, particularly about the military suspension, are very helpful in understanding how the written rules actually work.
If you have questions, or you think I’m confused, or you have an experience that would help others, please comment. These rules can impact your house-selling decisions. The choices you make can save or cost you a lot of money.
Another great article on this subject:
Favorable Tax Rules for Military When Excluding Capital Gain from Sale of Principal Residence
