Written by: Emily Wilson
One of the most common and least understood issues we face as military members who purchase property and then PCS is the tax treatment of any gains realized from the sale. As with all things tax-related, it depends. It depends on your circumstances, your total tax scenario, and your filing status, amongst other things.
When folks refer to the exclusion of capital gains from the sale of their property, they’re referring to Section 121 of the Internal Revenue Code. Section 121 allows taxpayers to exclude the gain from the sale of their primary residence. Most people who own and live in their home for at least two years will fully qualify for the capital gains exclusion (meaning you will not pay tax on the income earned from selling the home). The maximum exclusion amount for individuals who file single is $250,000– and the maximum exclusion for married couples filing jointly is $500,000. If the total gain from the sale exceeds these maximums, the taxpayer is responsible for paying capital gains tax on the excess. The taxpayer must meet specific criteria: ownership, residence (use), and look-back to qualify for this exclusion.
Criteria 1 – Ownership: If you owned the home for at least 24 months (2 years) out of the last 5 years leading up to the date of sale (date of the closing), you meet the ownership requirement. Only one spouse has to meet the ownership requirement for a married couple filing jointly.
What if I didn’t own the home for at least 24 months?
You may still qualify for a prorated maximum exclusion when you own the home for less than 24 months. If the reason for the move was due to a change of employment more than 50 miles away (an example of which is a PCS to a new duty station that is greater than 50 miles distant), health-related, or due to unforeseen circumstances, you will need to calculate the maximum exclusion for which you’re eligible.
A simplified method of this calculation is to divide the number of months you lived in the home by the months required (24) to determine the percentage of exclusion for which you’re eligible.
Example 1: An active-duty member purchased a home for $300,000, lived in it for 12 months, and then PCSed to a new duty station. The member sold the home upon moving for $400,000, with a single filing status. The maximum exclusion the member could have claimed as a single filer is $250,000 of gain if they’d lived there for the entire two years. Since the member only lived in the home for 12 months, the member must divide 12 by 24 (50%) and prorate the maximum by this percentage. The prorated exclusion amount for this individual is $125,000 ($250,000 x 50%) of gain. Since the gain, in this case, was $100,000 ($400,000 – $300,000), the entire gain is excluded from tax.
Example 2: An active-duty member and their spouse purchased a home for $600,000, lived in it for nine months, and then PCS’d to a new duty station. They sold the home upon moving for $800,000 and filed jointly. The maximum exclusion they could have claimed as joint filers is $500,000 of gain if they’d lived there for the entire two years. Since they only lived in the home nine months, they must divide 9 by 24 (37.5%) and prorate the maximum by this percentage. The prorated exclusion amount for this taxpayer is $187,500 ($500,000 x 37.5%) of gain. Since the gain in this case is $200,000 ($800,000 – $600,000), $187,500 of the gain is excluded from tax, and $12,500 is subject to capital gains tax.
Criteria 2 – Residence: If you used the home as your residence for at least 24 months of the previous five years, you meet the residence requirement. Unlike the ownership requirement, each spouse must meet the residence requirement individually for a married couple filing jointly to get the total exclusion.
What if I didn’t use the home as my residence for at least 24 months?
Like with our previous examples of members who PCS before meeting the 24-month requirement, an employment-related move is an exception to this rule. If applicable, the taxpayer (and spouse) will use the same method for calculating a reduced maximum exclusion based on the period they met the criteria (the number of months they lived in/owned the home divided by 24).
Criteria 3 – Look-back: If you didn’t sell another home during the two years before the date of sale (or if you did sell another home during this period but didn’t take an exclusion of the gain earned from it), you meet the look-back requirement. You may take the exclusion only once during a 2-year period.
What if I sold a home in the last 2 years and excluded the gain from my taxes on that property?
Once again, if the member moves for one of the aforementioned qualifying events (employment/health-related moves or due to unforeseen circumstances), the member will use the same method for calculating a reduced maximum exclusion based on the period they met the criteria (the number of months since they last sold a home for which they excluded the gain divided by 24).
What if I converted my home to a rental when I PCSed? How does that change my eligibility to claim the exclusion?
A popular real estate investment strategy for military members is to purchase homes at multiple duty stations for use as their primary residence while stationed at that location and then convert the home to a rental property upon their move. Military members benefit from a crucial additional exception to the basic requirement of owning and living in the home for at least 2 of the last 5 years. When a military member is on official qualified extended duty (active-duty orders for longer than 90 days or an indefinite period), they can effectively “stop the clock” on the 5-year timeframe for up to 10 years. This exception results in a military member being able to exclude the gain from a sale of a home they own if they lived in it for 2 of the last 15 years. The clock only stops during qualified official extended duty, so members who have non-continuous periods of active service will need to do additional calculations to determine their eligibility for exclusion.
An element of this investment strategy that members must consider is the unrecaptured section 1250 gain, commonly referred to as depreciation recapture. It is designed to recapture the portion of gain related to the previously used depreciation allowance. When a property is used for business purposes (as with a rental property), depreciation is a worthwhile (and required) business expense. Depreciation often allows property owners to experience positive cash flow while reporting a tax loss, meaning they pay no tax on that cash flow.
However, when it comes time to sell, you’ll need to pay tax on the depreciation you took if you sold your home for more than its purchase price. The maximum tax you can expect to pay on the depreciation taken is 25%, but it is less if you are in a lower tax bracket. When selling your home under these circumstances, it’s important to plan for this tax bill by setting aside up to 25% of the depreciation taken over the years.
Example 3: An active-duty member purchased a home in 2015 for $380,000. The member lived in it for two years before PCSing more than 50 miles away, converting the home to a rental upon departure. In 2021, the member sold the home for $650,000 and was active duty the entire time they owned it. From 2015 to 2021, the member took $67,251 in depreciation expense. The excludable gain from the sale was $202,749 ($650,000 – $380,000 – $67,251). The depreciation was subject to tax at ordinary income levels (not capital gains levels) up to a maximum of 25%. The member fell into the 24% tax bracket in 2021, based on all their income (including the taxable depreciation). The tax due on the depreciation was $16,140 ($67,251 x 24%). Their total tax bill also included their normal federal and state tax liabilities.
This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.
