This question often comes up when a military landlord owned and lived in a property, transferred away (PCS) for a few years and converted the property to a rental. Then the military landlord returns to the area and wonders if it is a good idea to move back in or not.
There are at least several factors to consider for this scenario. Does living in the home fit your lifestyle now? Does the military landlord want simpler, assuming that not having the property as a rental would be simpler? What are the opportunity costs? What are the financial advantages to moving into the rental property vs not moving into it? And then there are taxes and that is my focus here. And here is the shocker: I don’t think tax considerations should really drive the decision for most people – but you should understand the impact of converting that rental to a primary residence. And you should not believe some of the myths out there.
The first point is that if you have been able to take the special allowance for passive losses against your other income, you’ll lose that offset. For example, if your modified adjusted gross income (MAGI) for MFJ is $90,000 and you have a $10,000 passive loss due to the rental activity for a given year, then in many cases you’ll have at least $1200 less in Federal taxes due to that loss. Note this special allowance has requirements for qualification and is entirely phased out above $150,000 MAGI for MFJ filers. Also note don’t let this tax impact or the entire tax impact be the only driver in your decision. If it is costing you $10,000 a year to maintain the property and your net return on investment is negative, that $1200 reduction in taxes may not be very helpful overall.
Second point: What about my “military exemption” or better stated the suspension of the running of the 5 year rule due to qualified extended duty? Your duty station must be greater than 50 miles away from the home to be “qualified extended duty” IF your qualification was based on a PCS and distance. In that scenario, if you are transferred to a duty station within 50 miles of the property then you are no longer on qualified extended duty for that home. On a side note please remember you can only have one property suspended at a time.
Does that mean you need to move in? No. You MAY qualify for the “full” capital gains exclusion due to the sale of the home as long as you sell within the total time of 5 years plus the suspension period (not more than 15 years total). Usually you will need to have lived in the home for 730 days within that total time. Plus, as I stated above, other factors may help you determine that not moving in is better for you.
What if you never qualified for the suspension and/or you’ll go past the time and end up paying capital gains? If you have enough gain and/or income from the rental property you could net, over time, more even though you end up paying the capital gains taxes. Sometimes deferring taxes will give you a better net benefit than immediate tax avoidance. Please note that most landlords end up paying the part of capital gains that is known as depreciation recapture when they sell. There are strategies to delay and even avoid that entirely, but not part of this topic.
Third point, what about the depreciation? When you convert a rental property to a primary residence, you have effectively retired the property from service. So depreciation stops, but it is still there. The best practice is to keep it on a depreciation schedule that is carried forward with your tax returns from year to year, but make sure it is indicated as being retired or not active. Depreciation schedules are not actually sent to the IRS (usually), so it won’t cause them any confusion. Okay, I should say it shouldn’t cause them any confusion, as I’ve seen things.
The depreciation needs to be tracked because it lowers your basis and thus impacts your gain calculation. And typically it needs to be recaptured, meaning it will typically be taxed at a higher rate than any other capital gains that are taxed.
What happens if you move out at the next PCS and convert to a rental again? Then your basis on your “new” rental is the lower of the adjusted basis or the FMV of the property at the time of the “new conversion”. It will very rarely be the same as your previous rental basis. Your adjusted basis at the time of conversion will include an adjustment that decreases the basis due to the previous depreciation. Using the correct adjusted basis ensures that you don’t “double up” on depreciation. Your new life for the asset is 27.5 years, just like the first time around, even though you have already owned the property as a rental.
Fourth and final point, what if I don’t meet the requirements for excluding capital gains for the sale of a primary residence? Can I just move in for two years and then sell and exclude all the capital gains? No, not usually. This is because you likely have periods of what the IRS (and Congress) call nonqualified use. If you have a property for 8 years of nonqualified use and move in for two years and then sell after owning for 10 years total: 1/5th of the gains is allocated as qualified use and 4/5ths as non qualified use. The nonqualified use portion cannot be excluded. The qualified use portion can be excluded (assuming you are otherwise qualified to do so). Therefore, this strategy (moving in) can be used to reduce capital gains taxes, but not eliminate them. Please note that this example can’t directly apply to all situations, you may have more (or less) qualified use than you think.
The intent of this article is to provide some guidance on what to consider for tax questions on this topic. It is not intended to be the final authority on a given tax situation or to provide tax advice for your specific situation. I certainly haven’t covered all scenarios. You need to consult the applicable IRS publications and possibly the IRC and the CFR to sort out your particular tax situation. And/or consult a tax professional with experience in both rental properties and military tax provisions.