Favorable Tax Rules for Military When Excluding Capital Gain from Sale of Principal Residence

I asked my smart friend Paul Allen if he could possibly explain the capital gains exclusion in another way, especially the part about partial exclusions. I’ve always been confused by them. Even thought I’ve written about this here, I was still baffled about that part.

And Paul came back in a big way. I am so thankful, and I think I finally understand partial exclusions.

The exclusion of capital gains from the sale of your primary residence is one of the largest and most widely used tax breaks in the Internal Revenue Code (IRC). It’s an even better deal for military members and families because there are extensions built into the law giving military personnel and spouses the ability to take advantage of the exclusion for longer periods of time. The wording of the tax code is complicated, though, and I often see it misquoted or misinterpreted in online forums and social media. I thought I’d see if I could make the concepts a little clearer, so more military families take maximum advantage of this great tax break.

Capital Gains and Exclusions

When you buy something and then sell it for more than you paid for it you have created a capital gain. For example, I buy a share of XYZ stock for $100 and sell it for $150. I have a capital gain of $50. Under federal law, capital gains are taxed as income. While capital gains on assets held more than one year receive preferential tax rates compared to regular income, they are still considered income and subject to income taxes. Unless…

Unless that capital gain was generated due to the sale of your principal residence. IRC section 121 spells out the rules for this tax break. In short it says capital gains on the sale of your primary residence are excluded from income. If the capital gain on the sale was less than $500,000 for married couples filing a joint return, or $250,000 for all other tax filers, it is not necessary to report the income on your tax return.

Qualifying for the Exclusion

The basics for qualifying for the exclusion are fairly straightforward.

• Own the house for at least 2 years for the 5-year period ending on the date of the sale.
• Use the property as your principal residence for at least 2 years for the 5-year period ending on the date of the sale.
• You cannot have excluded gain from income under section 121 in the previous 2 years.

For simplicity I will refer to the ownership and use ‘2 of the prior 5 years rules’ collectively as the “2-in-5 rule”.

If you need the expanded $500,000 capital gain exclusion of married couples filing jointly, only one of you has to have owned the property for 2 of the 5 years prior to the sale, but both of you must have lived in the property as your principal residence for 2 of the previous 5 years. Neither of you can have excluded income under section 121 in the previous 2 years.

Partial Exclusion

Editors note: This part is the reason that I asked Paul to write this article for us. I’ve never quite gotten this right until now. Thank you, Paul!

The 2-in-5 rules for ownership and use of the property do not apply if the sale or exchange happened because there was a change in place of employment, health, or other unforeseen circumstances (as approved by the Secretary of the Treasury). This is quite a common occurrence with military families. You think you’re going to be homesteading in the same location for a couple of tours, so you buy a house. Then 12 months later you get hit with the surprise your detailer was hiding behind door number 2, and you are PCS-ing.

The first good news is this counts as a change in place of employment and the 2-in-5 rules are waived. The bad news is the maximum amount of capital gain exclusion is limited by the ratio of time of use/ownership to 2 years. The second good news is this almost never matters to military service members because the actual capital gain is nearly always less than the reduced maximum exclusion amount. Let’s look at an example:

Denny, a soldier stationed at Fort Eustis, buys a house in Williamsburg on 1/1/2016. He lives in it until 1/1/2017 but must move to Fort Hood (more than 50 miles) to comply with official orders. He sells the house on 1/1/2017 and realizes a capital gain of $25,000. The 2-in-5 rules are waived for Denny, but his maximum exclusion is reduced by 50% (1 year use&ownership/2 years). His maximum section 121 exclusion amount is $125,000 – half of the normal $250,000. For Denny this has no impact. He can still exclude the entire $25,000 of capital gain from the sale of the house from his income.

Periods of Non-Qualified Use

A period of non-qualified use is any period of time during which the property was not being used as the principal residence of the taxpayer or taxpayer’s spouse. Having periods of non-qualified use can be particularly harmful to this tax break because the amount of the actual capital gain excluded from income is reduced by the ratio of non-qualified periods to the total period of ownership. This is very different than the reduction in the maximum exclusion when the 2-in-5 rule is waived. That’s a lot of words, let’s look at a quick example:

Benny has a capital gain on the sale of his house of $30,000. He owned the house for a total of 90 months. 30 of those months were a period of non-qualified use. The amount of the capital gain he can exclude is reduced by 1/3 (30 months/90 months). Benny’s exclusion is $20,000, and he must declare $10,000 as capital gains income on his tax return.

Nobody panic! Periods of non-qualified use are easy to avoid (and even easier if you are military!)

There are exceptions to periods of non-qualified use. If you are within the 5-year time period for determining eligibility for the exclusion the most common exception is the period of time AFTER the LAST time you used the house as your primary residence. I added the emphasis because I see this misquoted and misunderstood often. Let’s look at two examples:

1. Jenny bought a house on 1/1/2014. She lived in it as her principal residence until 1/1/2017. From 1/1/2017 until 1/1/2019 she rented the house to tenants and lived elsewhere. She sold the house on 1/1/2019. All of Jenny’s use of the property is considered qualified time for the section 121 exclusion. The time the property was not her primary residence was AFTER the LAST period it was her primary residence and did not bust the 2-in-5 rule.

2. Manny bought a house on 1/1/2012. He lived in it until 1/1/2015. From 1/1/2015 until 1/1/2017 Manny rented the house to tenants and lived elsewhere. On 1/1/2017 he moved back into the house and lived there until 1/1/2018. From 1/1/2018 until 1/1/2019 he rented it to tenants and lived elsewhere. On 1/1/2019 he sold the property for a capital gain of $70,000. He satisfies the 2-in 5 rules, however, the period from 1/1/2015 until 1/1/2017 is a period of non-qualified use. It is not AFTER the LAST time Manny lived in the property as his principal residence. Even though he was not living in the house, the period form 1/1/2018 until 1/1/2019 is qualified because it is AFTER the LAST time he used the property as his principal residence. 2 of the 7 years he owned the property are non-qualified, therefore the capital gain exclusion is reduced by 2/7ths. Manny can exclude $50,000 but must declare $20,000 from the sale as capital gains income.

Military Personnel Get an Exception to the Above Rules on Non-Qualified Use

Our lawmakers gave military personnel a nice 10-year pass on the periods of non-qualified use rules. Any period during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty is excepted from the rules on non-qualified use. Qualified official extended duty means an active duty military assignment of more than 90 days more than 50 miles from the house. The aggregate of qualified official extended duty cannot exceed 10 years. Let’s look at another example:

Lonnie, A US Marine, bought a house in Virginia Beach on 1/1/2008. She lived in it as her principal residence until 1/1/2010. She got orders to Jacksonville (more than 50 miles away) and rented it to tenants until 1/1/2014. She moved back to Virginia Beach and lived in the house from 1/1/2014 until 1/1/2017. She got orders to Okinawa and rented the house to tenants until 1/1/2019. She moved back into the house on 1/1/2019 and lived in it until 1/1/2020. She sold the house on 1/1/2020. Lonnie has no periods of non-qualified use. All the periods when the house was not her principal residence are covered by the fact that she was on qualified official extended duty. The aggregate of those periods does not exceed 10 years. She meets the 2-in-5 rule. She qualifies for all $250,000 of the capital gain exclusion on the sale of the house.

The 10-Year Suspension on the 2-in-5 Rule for Military

Military personnel on qualified official extended duty can also suspend the 2-in-5 rule on use of the home as primary residence for up to 10 years. That can effectively make it a 2-in-15 rule. Let’s look at a couple more examples.

1. Johnny, a US Navy Sailor, buys a house in Virginia Beach on 1/1/2005 and lives in it until 1/1/2007. He received orders to San Diego and rents his Virginia Beach house to tenants beginning 1/1/2007. He gets married in California on 1/1/2010. Johnny does consecutive west coast tours and continues to rent his Virginia Beach house to tenants the entire time. He sells the house on 1/1/2020 for a capital gain of $300,000. Johnny qualifies for the capital gain exclusion of $250,000. He lived in the house for 2 years and owned it for 15. He receives an additional 10 years on the 2-in5 rule for being on qualified official extended duty. Although married and filing jointly, he does not qualify for the $500,000 exclusion because the house was never his spouse’s principal residence. Only $250,000 of the gain is excluded. Johnny will need to report $50,000 of capital gains income on his tax return for 2020.

2. Vonnie, an Airman in the USAF, buys a house in Virginia Beach on 1/1/2010. She lives in it until 1/1/2012 when she receives orders to Arizona. She rents the house to tenants beginning 1/1/2012. Vonnie moves from Arizona to South Dakota in 2015. On 1/1/2019 Vonnie separates from the USAF but remains in South Dakota. If Vonnie sells her Virginia Beach house by 1/1/2022 she can still get the full $250,000 capital gain exclusion. If she sells between 1/1/2022 and 1/1/2024 she will not meet the 2-in-5 rule even with the suspended time, but since she was forced to move from her house by military orders she can still claim a pro-rated share of the maximum exclusion. After 1/1/2024 she will not qualify for any exclusion of capital gains on the sale of the house.

That last part merits a little more discussion. From 1/1/2012 to 1/1/2019 Vonnie is on qualified official extended duty, so it is suspended for calculating the 2-in-5 rule. The clock starts running on 1/1/2019. As of 1/1/2022 the 5-year period is 1/1/2010 to 1/1/2012 when she lived in the property plus 1/1/2019 to 1/1/2022 when she did not. She meets the 2-in-5 rule until 1/1/2022. After 1/1/2022 she does not meet the 2-in-5 rule, but she qualifies for a pro-rated part of the exemption until 1/1/2024.

The section 121 rules do not exclude recaptured depreciation from income. Not even for military families. You will still have to pay the tax man for the depreciation recapture if you sell a property after it has been a rental.

That was a lot. I hope it gives you some clarification on a complex topic.

Paul D. Allen CFP®, EA is a retired Navy Officer and a fee-only, fiduciary financial planner. He is a founding partner in Redeployment Wealth Strategies, a financial planning firm focused on serving military and veteran families. He is also a founding partner in PIM Tax Services, a tax planning and preparation firm focused on serving military and veteran families. He recently accepted the position as Director of the CFP Board Registered Program at Regent University’s School of Law where he strives to positively influence the next generation of genuine financial planners. Paul lives in Virginia Beach with his wife Tade and their dog Abbey.