Disclaimer: We think this tax rule is an important one for Armed Forces members to know about. However, as a friendly reminder, information in this blog post is meant to be used as a helpful guide and for educational purposes only. It is not to be taken as tax or legal advice. If you need help navigating your taxes, please contact a skilled CPA.
In October 2001, a member of the Armed Forces named Brian bought a home. A few years later in April 2004, Brian and his family were deployed out of state. He kept ownership of his home throughout his military career but never moved back.
Fast-forward 12 years to November 2016: Brian sold the home, resulting in a capital gain of about $21,000. He filed his own federal income taxes through a DIY program and paid the taxes he believed he owed on that gain.
A couple of years later, Jeremy Kniffen, a practicing CPA in Colorado for more than 20 years, took on Brian as a client. Kniffen asked if Brian had heard of the capital gains tax exemption for military members. Brian said no — but would Kniffen help him amend his tax return? Kniffer agreed and, using the military exemption, Brian received a refund of approximately $3,800.
That was just one of dozens of instances when Kniffen has helped his clients use the “stop the clock” exemption, a little-known tax rule which makes it easier for members of the military to keep their home sale taxes to a minimum. So just what is this tax rule and how do you know if you qualify? We spoke with several CPAs for guidance — read on to hear what they said!
How are capital gains normally taxed?
Anytime someone sells a capital asset — such as a car, stocks, or a house — for more than the adjusted basis (the cost paid for it minus any capital improvements made), the IRS will assess a capital gains tax of anywhere from 0%, 15%, or 20% depending on the person’s income.
Here’s an example:
You bought your home in the year 2001 for: $300,000
You sold it in 2021 for: $540,000 (marking 4% yearly appreciation)
Before selling, you invested in the following improvements:
- Kitchen renovation ($40,000)
- New roof ($20,000)
- New deck and paver patio ($25,000)
Your settlement costs amounted to:
- $25,200 in agent commissions
- $15,000 in other closing fees
From here, you can calculate your capital gain like so:
$499,800 (sale price – settlement costs)
$385,000 (cost basis, i.e., the original price + the total cost of capital improvements)
A capital gain amounting to $114,800*
If you’re taxed at the 15% range, Uncle Sam would take a hefty $17,000 of that profit amount — but luckily, most homeowners won’t have to fork that over, thanks to the capital gains tax exclusion.
What’s the capital gains tax exclusion?
According to the current tax code, when any homeowner (even non-military) sells a house, they don’t have to pay capital gains taxes as long as their profit doesn’t exceed $250,000 for single filers or $500,000 for married-filing-jointly.
So in the example above, the $114,800 capital gain is far less than the cap, which means you wouldn’t have to share any of your profits with the IRS.
There is, however, a catch. To qualify for the exclusion, the homeowner must meet these three criteria:
- They must have lived in the house for at least two of the previous five years.
- They must have owned the house for at least two years.
- They can only claim the exemption once every two years.
What’s the military tax exemption?
When someone is serving in the military and receives a Permanent Change of Station (PCS) that forces them to move out of their primary residence for a long period of time, it may be impossible to qualify for the general capital gains tax. In Brian’s case, he was living away from his house for 12 years, so he wouldn’t have met the standard “use test” that required him to live there for at least two of the past five years.
That’s where the “stop the clock” exclusion comes in. According to the current tax code, if a homeowner or their spouse is a member of the U.S. military or the intelligence community and their service requires them to live outside their home indefinitely or for longer than 90 days, they are allowed 10 additional “suspension” years on top of the five “test” years that everyone else gets.
So instead of having to live in the house for at least two of the past five years, they would only have to live there for two of the past 15 years to avoid paying a capital gains tax when they sell.
Back to Brian: Did he meet the test using the military exemption? Yes — here’s how.
Remember, Brian sold his house in November 2016. The military-specific suspension period of 10 years, in this case, extends back to November 2006. On top of that, the test period extends back an additional 5 years, to November 2001.
To meet the ownership and use tests, Brain would need to have owned and lived in the house for two years between November 2001 and November 2016. And he did!
Between November 2001 through April 2004, he had 2.5 years of owning and living in the house within the suspension and test period of 15 years. So, he qualifies for both the use and ownership tests and doesn’t have to pay capital gains on the sale up to the government thresholds.
Why not just sell the home?
According to the USAA, which offers insurance and financial products and services to U.S. military families, one in five of its members move each year. For many of those homeowners, especially the ones who need to vacate quickly, it’s often quicker and easier to rent out their homes than to list and sell them.
Choosing to become a “military landlord” also provides a host of other benefits:
- You’ll be able to move back into the house after deployment is over.
- You’ll have the opportunity to build equity in the home while the renter pays down the mortgage (and could even earn monthly revenue, although that part could be taxable as rental income).
- There is the opportunity to receive tax write-offs for the rental property, including for mortgage interest, property taxes, maintenance, improvements, and repairs.
- If you have a personal attachment to the house and want to keep it in the family without living there, taking on a tenant can cover the mortgage in your absence.
Who qualifies for the military gains tax exemption?
The IRS is pretty specific about who is eligible for the extra 10-year suspension. To qualify, the service member must be performing “qualified extended duty,” which means they have been “called or ordered to active duty for an indefinite period, or for a definite period of more than 90 days.”
They must also be serving at a duty station at least 50 miles from their main home, or “living in government quarters under government orders.” That means if the homeowner moves back within 50 miles of their home, or if they are no longer on active duty, they are no longer eligible for the exemption.
Wondering if your (or your spouse’s) military role is eligible for the exemption? Consult the IRS’s complete list of who qualifies.
The fine print: More details you should know about the exemption
Beyond the basic 10-year suspension allowance, there are a few more important details and rules you should know about the “stop the clock” clause.
- Service records may be required: Bret Scholl, CPA, CGMA, has been operating his own accounting practice in California since 1985. Scholl has worked with around a dozen stop-the-clock exceptions over the years, most of which have been for multiple foreign deployments for military and government service clients. Scholl recommends keeping sufficient service records in case you need to prove to the IRS that you qualify for the exemption.
- One at a time: If you own two properties while deployed, you can’t apply the “stop the clock” exemption to both of them. The exemption can be used sequentially — i.e., if you apply it to the sale of one home, then buy another home, and then are deployed again — but not simultaneously.
- The “recently left” rule: There is a somewhat vague clause in the exemption that states “this extension of time can apply to taxpayers who have recently left the military.” It doesn’t clarify what timeframe would qualify as “recently,” so be sure to ask your tax professional if you’re uncertain about your eligibility.
- Rental income taxes: Tim Yoder, a certified CPA with over 25 years of accounting experience and a tax analyst at FitSmallBusiness, points out another thing to keep in mind: “If you collect rent from the house during the five-year period (plus up to 10 years while on qualified official extended duty), you will need to pay income tax on any profit,” he says. “When you sell the house, you must recognize capital gain up to the amount of depreciation you were allowed to deduct against rental income. This is still a great deal, because any appreciation of the house that occurred during the five- to 15-year period is excluded up to $250,000 ($500,000 per couple).”
Selling any home involves some hiccups along the way, but selling an unoccupied property while you’re deployed on active duty comes with its own unique challenges. We hope this guide has been helpful in demystifying the military capital gains exemption, but it’s wise to pair this information with guidance from your tax professional to help put you at ease.
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