For many homeowners, selling a primary residence doesn’t incur a tax bill thanks to the capital gains exclusion. The IRS allows homeowners to exclude up to $250,000 (or $500,000 for married couples filing jointly) of capital gains from taxation if they meet certain requirements. However, military service members receive a unique extension that recognizes that they rarely control where they live.
Understanding how this military extension works is crucial if you plan to turn a primary residence into a military rental. And while your property manager might be great at caring for your property, they probably don’t thoroughly understand the nuances of this special rule. Not understanding this rule could cost you a lot of money.
The Capital Gains Exclusion: A Quick Overview
Under the regular rules, the IRS allows you to exclude up to $250,000 (single) or $500,000 (married) of profit from a home sale from taxation if:
- The seller owned the home for at least two years of the five years immediately before selling.
- The home was the seller’s primary residence for at least two years of that five-year period.
Many service members convert their homes into rental properties when they PCS. However, renting a home for an extended period typically means falling outside the IRS’s five-year look-back. The military extension prevents service members from losing their capital gains tax break simply because they moved on PCS orders.
How the Military Extension Works
Under Internal Revenue Code §121(d)(9), service members can suspend the five-year look-back period for up to 10 additional years if they receive PCS orders to a location at least 50 miles away from their home. This means that instead of having just five years to meet the two-year residency requirement, a service member could potentially have up to 15 years to sell the home while still qualifying for the capital gains exclusion.
This flexibility allows military members to hold on to a home if they may return to the area, if the market doesn’t support selling when they get orders, or if they otherwise prefer to rent instead of selling.
What You Can and Can’t Do with the Exemption
While this rule provides great flexibility, there are limits. First, you must be absent from the property due to qualified military orders. Second, the exemption does not waive capital gains entirely—it only extends the qualification period. And, you can only apply the suspension to one property at a time. Lastly, you can only suspend one property at a time.
Importantly, this rule does not impact the deprecation portion of the capital gains. Unless you lose money on the property, you’ll be charged the taxes on any depreciation, even if you choose not to take it.
An Example: How the Military Extension Could Benefit You
For example, let’s say that Stevie Soldier bought a house in 2010 and moved in. In 2012, they received PCS orders and rented the home out, hiring a property manager to handle tenants.
Under the usual rules, they would need to have sold the home by 2015 to utilize the capital gains exemption. But because they can suspend up to 10 years, they can use the capital gains exemption as long as they sold the home by 2025, or sooner if they left the military.
Maximize Your Financial Potential with the Capital Gains Exemption
Understanding this rule can impact when you choose to sell a property to avoid unnecessary taxes. If you don’t understand it well, get tax advice from a professional, preferably one who specializes in the unique tax needs of military members. A good tax strategy will keep track of all the important deadlines based on the specifics of your situation. Correctly calculating the portion of the gain that is attributed to excludable capital gains can be tricky.
The military extension to the capital gains exemption can be a major benefit for service members, allowing them to qualify for tax-free home sale profits even if they’ve been away on PCS orders for years. By understanding and leveraging this rule, military families can maximize their home’s financial potential and avoid a larger-than-necessary tax bill down the road.
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