It is amazing how many people feel like they know enough about this topic to provide tax advice on it – often the wrong tax advice – when they don’t have knowledge of the applicable IRS publications, the IRC, and the CFR. I have had lawyers, real estate agents, and property managers tell my clients they were qualified for a capital gains exclusion when they were not and also tell my clients they were not qualified when they were qualified.
The intent of this writing is to share what is NOT true and to provide some guidance on where to look to determine accurate answers to tax questions on this topic. It is not intended to be the final authority on whether or not you are eligible for having capital gains excluded from taxation or to provide tax advice for your specific situation. I am not going to cut and paste the IRC into this article. If you are reading this to determine if you are eligible for capital gains to be excluded from taxation you need to consult the applicable publications and possibly the IRC and the CFR. And/or consult a tax professional with experience in both rental properties and military tax provisions. Based on my experience with clients who come to me after DIY tax return preparation and tax returns prepared by professionals, the error rate for tax returns with rental properties tends to be high. Note that tax laws change, and this article may or may not keep up with any changes.
This is the first of a series of articles related to rental property and taxes. Generally the discussion will address federal taxation. In most cases state income tax law will follow federal law for this topic, but don’t assume that is true for the state you are concerned about without researching first. The next article will be how to choose the right tax professional. The third will be about depreciation errors. More to follow after those.
The five year rule
The short version is this: If you own a home for 730 days or 24 months or more (and they do mean 24 months, 23 months and 27 days is not 24 months) and the home is your primary home for that period of time you MAY be eligible to exclude some capital gains from taxation. I say MAY because there is an eligibility test. Without stepping through the eligibility test no one can actually state with certainty that you are eligible for excluding some capital gains from taxation. You can find the eligibility test on page 3 of Publication 523. If it looks like you don’t qualify for the exclusion of the gain move on to page 4 of Publication 523 and see if you meet any of the exceptions to the eligibility test. Note that what many people call the military extension (or military exclusion or military exemption; I don’t and I’ll explain later why that is) is part of the exceptions.
The full exclusion of capital gains is $250,000 for filing as one taxpayer or if only one spouse qualifies and $500,000 if both spouses qualify and file jointly (page 3 of Pub 523). If you don’t meet the requirements of the eligibility test for a full exclusion and/or you don’t meet any of the exceptions, then take a look at what qualifies you for a partial exclusion. This is found on page 6 of Pub 523. A simplified example of the partial exclusion is that if you would otherwise qualify for a $500,000 exclusion of capital gains, but you only lived in the house for 365 days (half of 730 days) then your max exclusion of capital gains is $250,000. Often that is plenty of room to avoid capital gains taxes. Once you have verified the partial exclusion applies, you can use Worksheet 1 in Pub 523 (page 7) to determine the amount of the capital gains exclusion.
Note that the simplified definition for capital gains is how much money you make on the sale, not necessarily how much money you walk away with nor the total sales price. There are rules (and laws) on how to determine both basis and capital gains. Ballpark estimates are just that if those rules haven’t been followed. I’ll cover those in a later article.
Also, please note that if you move into a home after you have used it as an investment property and then sell it as a primary home you MAY find yourself in the position of having both qualified and nonqualified use in regard to the Section 121 exclusion of capital gains (another good article I think, since qualified extended duty isn’t considered nonqualified use). If you are in this situation you’ll likely have both gains excluded from taxation and gains subject to taxation. That situation is not a focus of this article and neither is any impact of a 1031 exchange.
- If I qualify for the capital gains exclusion on the sale of a primary residence I don’t have to pay any income taxes.
I say myth primarily for three reasons. One, as I just mentioned above, if you have nonqualified use then you may have taxable gains. Two, your gains may exceed the maximum exclusion amount. Three, you may have taxable gain if you have depreciated the house at all or if you should have depreciated the property and therefore have to pay depreciation recapture. If none of those things are true (and if you qualify for the exclusion) then you won’t have any federal income taxes on the sale of the home.
You may have depreciated if you had business use of a portion of the home or you may have depreciated if it was used as rental property. Depreciation recapture is basically how the government has you make up for the benefit of depreciation you’ve taken in the past. Even if you didn’t take depreciation, if it was allowed then in most cases you should have taken it and the IRS (and Congress) expects you to take it (Pub 544, Pub 946). Therefore depreciation recapture applies for rental property even if you didn’t take depreciation due to an error or because you didn’t want to bother with it. Unless it wasn’t allowed, which is not common for military landlords.
Depreciation recapture is a form of gain (Unrecaptured section 1250 gain) which is why it is discussed when discussing gain and why some people will look back at a tax return and be confused because it may look like you paid capital gains taxes when you thought they were excluded.
Here is an over-simplified example to explain how this works. But this math will NOT get you an accurate answer for your own gain.
Initial basis for rental property – $100,000
Total Depreciation over time – $50,0000
Sale price – $300,000
Total basis = $100,000 – $50,000 (depreciation) = $50,000
Total gain = $300,000 – $50,000 = $250,000.
This looks like you are good to go if you qualify for a $250,000 exclusion. But since $50,000 of that $250,000 gain is due to depreciation and is considered section 1250 gain, it cannot be excluded from taxation (in this scenario- a “regular” house sale). So you have $50,000 of depreciation recapture.
Depreciation recapture is taxed as ordinary income, at your marginal tax rate, up to a 25% maximum (usually). This differs from long term capital gain taxes that can be 0%, 15%, or 20% depending on your total income level.
I’ll mention here that if you have depreciation errors on your tax return they usually can be fixed and sometimes that can be to your advantage. And usually they should be fixed. The IRS generally expects errors to be fixed when taxpayers realize an error has occurred. Again, I’ll address depreciation errors in a later article.
- You have to be on active duty to use the military extension. As long as I am active duty I can take the capital gains exclusion for up to 15 years.
Not accurate. This is the last time I will say military extension, because that term causes so much confusion and many misconceptions. What matters is whether or not there is qualified extended duty and how long the qualified extended duty was. What matters is whether or not the qualifications for the suspension of the 5 year rule for qualified extended duty are met or not. There are civilians who have not had any military service who can qualify for this suspension.
Qualified extended duty is:
- When you are called to active duty for an indefinite period of time or for more than 90 days. This means that if you are a reservist under active duty orders or a National Guard member under active duty orders (Title 10), these orders MAY help you to meet the requirements of qualified extended duty.
- And when you are serving at a duty station more than 50 miles from the home in question or you are living in government quarters under government orders.
- And see Pub 523 for specifics on what qualifies for qualified extended duty besides military service.
- 10 years or less. It is important to note the “less”. When you no longer meet the requirements for qualified extended duty (#1, #2, and #3 above) then you are no longer eligible for the suspension to continue.
Your total time can be no more than 15 years. 5 years (the 5 year rule) and up to 10 years suspended. So if you only have 8 years of qualified extended duty, then the max time is only 13 years.
- I can suspend the 5 year rule for every house I PCS from.
False. You can only suspend one property at a time under the qualified extended duty rule. But you can change your mind about which property is being suspended at any time (Pub 523 page 5). You can do multiple suspensions over your lifetime, but the suspension times cannot overlap.
- I can’t use the suspension once I separate from service or retire.
False. Unfortunately the wording of Pub 523 helps to perpetuate this myth. But if you read closely you’ll see that Pub 523 does NOT indicate that you have to be on active duty or still on qualified extended duty when you sell the home or file the tax return. When the qualified extended duty is over, then the suspension period is over. The running of the 5 year rule now continues. If you have a full 2 years of eligible time for the 5 year rule before suspending for qualified extended duty, then once that duty ends you have 3 years to sell the property to be able to take advantage of the 5 year rule for excluding capital gains for the sale of your primary residence-if you don’t move back into the property.
Some people will insist that what I just stated is wrong. Those people have not done adequate research. IRS instructions and publications can be helpful, however the Internal Revenue Code (IRC) matters more. And the Code of Federal Regulations (CFR) can be helpful. On some occasions IRS revenue procedures, IRS rulings and court cases can drive the determination of the answer to a tax issue.
In this case the wording in Pub 523 differs some from the IRC: 26 US Code Section 121. I don’t view Pub 523 as wrong, just poorly worded. The tax code states “at the election of an individual” the running of the 5 year rule may be suspended for the period of time the individual or spouse is on qualified extended duty. It does NOT state “at the election of an active duty service member”. It does NOT indicate that a taxpayer has to be on qualified extended duty at the time of the sale or upon filing the tax return.
But for those people that don’t view that as enough, we are fortunate that the CFR provides some additional guidance and that can be found here, 26 CFR Section 1.121-5. The government has kindly provided an example, which you can see under (d). The example is for foreign service, but this section applies to the qualified extended duty for service members and foreign service. Note that the taxpayer ends qualified extended duty in 2014. The taxpayer has 8 years of suspending the 5 year rule. In 2015 the taxpayer sells the home in question and may use the exclusion of gain for the sale of a home under section 121. One year after the qualified extended duty the taxpayer sells the home and qualifies for capital gains to be excluded.
You don’t have to be on qualified extended duty, be on active duty, or be in foreign service when the home is sold or when the tax return is filed.
Hopefully by this point you realize why stating “the suspension of the 5 year rule due to qualified extended duty” is better than stating “military extension” or “military exemption”. It describes what is being done better and leads to fewer false conclusions. That is my soapbox.
- I can’t exclude capital gains from taxation more than once every two years.
This is false. Social media fact checkers (if they knew taxes) would say partially true. This is a great example of how not being familiar with the tax code (and pubs and instructions) can be a problem. If you just read one part – you may be missing some important information. One of the biggest ways to have mistakes in tax preparation is not knowing what you don’t know. How could you? Diligent research. That is what separates good tax professionals from bad ones. Well one thing, ethics would be another and there are more differences
If you look at Pub 523 page 3 under Eligibility Step 4 Look-Back, the last sentence is “You may take the exclusion only once during a 2-year period”. That sounds very clear. However, if you look at the requirements to be eligible for the partial exclusion of gain on page 6, you’ll note that there is no time requirement. If you go further, and look at the calculation for the partial exclusion limit you’ll find that the calculation uses the shortest of 3 timeframes: time owned, time lived in the home, and the time since the last time a home was sold and capital gains were excluded.
This means as long as your second (or third or more) home sale within 2 years qualifies for the partial exclusion, you can have more than one home sold within two years and have capital gains excluded on each home. You can have more than one home with excluded capital gains in the same year. But only the first home could be eligible for the full exclusion and any subsequent homes have to qualify for the partial exclusion (when within 2 years).