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For many military families facing a PCS, converting their primary home into a rental can be a smart financial move, and an excellent way to grow wealth.
But when it comes time to sell the home, things can quickly become complex. Between IRS capital gains tax rules, depreciation recapture, and state taxation implications, it’s critical to understand what you may owe—and how to minimize your tax burden.
Understanding Capital Gains vs. Depreciation Recapture
When selling your home, ideally, you’ll walk away with a handsome profit. This “profit” can be subject to taxation, specifically as capital gains and depreciation recapture.
Capital gains: taxes on the increase in the value of an investment (your home). These can be assessed at both the federal and state level.
Depreciation recapture: If your property has been a rental at any point, you will also need to account for the depreciation deduction you have hopefully taken each year you’ve operated the home as a rental. When you own a rental property, you are eligible for several deductions, and depreciation is a significant one. Depreciation recapture is the IRS’s way of reclaiming tax benefits that investors receive when they sell an asset for a gain. Depreciation recapture is calculated as a separate tax line item from capital gains taxes and is typically taxed at your ordinary income tax rate.
How Are Capital Gains Levied?
Capital gains tax rates can range from 0% to 20%, and are based on your total income and how long you've owned the asset.
According to the Primary Residence Rules, a single taxpayer can exclude up to $250,000 in federal capital gains, or $500,000 if married filing jointly, providing they've used the property as their primary residence for two years out of the last five (24 months out of 60).
The two years of residency do not need to fall in any particular order within the five-year ownership period. Additionally, if you didn't use the property as your primary residence for a full 24 months, you may still be eligible to claim a prorated exclusion, but eligibility requirements apply, such as a change in job location, a health issue, or an unforeseen circumstance such as divorce, death, or natural disaster. It's important to note that the federal capital gains exclusion may be claimed for a single property at a time, and only once within a two-year period.
The simplest way to understand capital gains tax as it relates to a property is to think of it as a profit on selling the home.
Potential Taxable Gain = Difference between selling price and adjusted basis.
Adjusted basis = the original purchase price of the home + purchase expenses + selling expenses + any qualifying capital improvements (such as a new roof), minus depreciation.
The next step is to determine if the taxable gain qualifies for any tax exemptions, such as the Primary Residence Rule.
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The Military Extension to the 5-Year Primary Residence Rule
The IRS offers a primary residency rule extension to military service members on “qualified official extended duty” to suspend the five-year ownership period for up to 10 years.
This suspension extends the total look-back period to 15 years (the regular 5 years + up to 10 years for military duty). To be on qualified military duty, a member must be stationed more than 50 miles from their primary residence for over 90 days or reside in government quarters under orders.
Example:
- A service member buys and lives in a home for three years.
- They receive PCS orders and rent the house out for seven years.
- After being away for seven years, they decide to sell the home.
Under the regular Primary Residency Rule, they would not qualify for a capital gains exclusion, because they did not live in the home for two of the past five years.
But with the military extension, they can suspend the five-year test period during their seven-year absence. They still meet the “lived in for two years requirement” as a former primary residence, within the extended 15-year period. (Note: Remember that the suspension is for capital gains only—depreciation recapture tax still applies for the seven years that the home was used as a rental).
This extension helps service members keep their tax break when a PCS move would normally make them ineligible and helps preserve wealth despite frequent relocations.
If you’re relocating due to orders, understanding the market for military houses for rent near your new base can help with planning while your previous home is still on the market. See our free guide below on help for making the decision whether to rent or sell.
State Capital Gains Taxes Still Apply
Federal tax rules, however, may be just the beginning of the tax puzzle for military families. Even if you qualify for the federal capital gains exclusion of $250,000 (or $500,000 filing jointly), some states still levy a state-level capital gains tax on home sale profits. This can be especially confusing for military families who maintain residency in one state, but sell a home in another.
For example, you might be a legal resident of Tennessee (which does not have a state income tax), but if you sell a rental property in Maryland, the state of Maryland may still require you to:
- File a non-resident state tax return
- Pay state capital gains tax on the profit from that property’s sale
But what if your home state of residency also taxes worldwide income? That’s where it gets even trickier.
Double Taxation: Understanding and Mitigating State Capital Gains Taxation
Take the case of a military family who are residents of California, a state which levies both a state income and capital gains tax on its residents on worldwide income, but sell a home in Maryland (a state which also levies a state income and capital gains tax).
Maryland will tax the gain as income sourced to property in its state. Non-residents must file a state income tax return and often face an automatic estimated withholding at closing.
California, because it taxes residents on all worldwide income, will also expect the profit to be reported on the California state return.
The result? Both states claim taxing rights on the same income.
The good news is that most states, including California, allow a credit for taxes paid to another state. This prevents you from paying the full tax twice, but you’ll still owe the difference if your residency state’s tax rate is higher.
Example of a California resident selling a home as a non-resident in Maryland:
- Profit from a Maryland home sale = $100,000
- Maryland capital gains tax owed as a non-resident = $6,000
- California tax on the same income = $9,300
You’d pay Maryland $6,000 and then claim a credit on your California return. California applies that credit, but still charges the additional $3,300 because its taxation rate is higher.
While you won’t usually pay both states in full, you can absolutely owe taxes in both states—and your home residency state may end up taking the bigger bite.
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Navigating State Capital Gains Taxation and Potential Exemptions
Planning ahead can help you avoid tax issues if you expect to owe state capital gains taxes.
- Check both states’ rules early in the process (where the home is being sold, and your home of record).
- Compile federal and any state tax returns for the years during which the home operated as a rental.
- Compile PCS orders placing you in the state where you purchased the property (then converted it into a rental), and PCS orders placing you away from the state, to prove to both a military and non-residency exemption to the IRS and state taxation entities. Also, prepare proof of your permanent home of record, such as your most current Leave and Earnings Statement (LES), if you are claiming non-residency.
- Research and pursue any qualifying state exemptions available to military members or non-residents, particularly timelines and stipulations to request an exemption.
- Anticipate and plan for potential mandatory capital gains withholding at closing in the selling state.
- Work with a tax professional who understands multi-state filings, especially if your residency state taxes worldwide income, to understand your tax liability and required filing requirements.
Some states may offer a full or partial exemption of state-levied capital gains taxation where the home sale is taking place, but you’ll likely have to file for it through the state comptroller or franchise tax boards. Anticipate strict filing deadlines as well, such as 30 days prior to closing, for any exemptions to be reviewed and a decision made.
If there’s ever a time to lean on your military network, it’s now, when finding a seasoned professional who thoroughly understands how to navigate non-resident home sales can help you sell your home while identify qualifying tax and residency exemptions.
Learn the top questions you should ask your real estate agent.
The Bottom Line
Turning a primary home into a rental is a smart move for many military families facing PCS orders. But understanding the tax landscape when it comes time to sell can help you maximize your gains, stay compliant with IRS and state rules, and keep your financial footing steady—no matter where the military (or life!) sends you next.
Thinking about selling your home? Learn the essential steps for a successful closing with MilitaryByOwner’s free home selling guide, with over 40 pages of expert guidance to help you learn effective pricing strategies, marketing tips, what to expect at closing and much more!
