It turns out service members (and their spouses, if they have one) often don’t get to live in a house for at least 24 months or 730 days. This is one of the requirements to exclude capital gains from taxation due to the sale of a primary residence under Section 121 of the tax code..

Fortunately, there is the partial exclusion. Under certain circumstances a taxpayer can qualify for a partial exclusion of the capital gains. The partial refers to reducing the maximum you can exclude under section 121 from $500,000 (if filing MFJ) or $250,000 down to a lower number.

When using the partial exclusion you still count days like you do under the full exclusion rule, but you can have fewer of them. When qualifying for the partial exclusion you can also have less than 2 years between a previous sale of a home using the exclusion and the “current” sale. Whichever is lower- the days you used the property as your primary residence or the days you have in between (if less than 2 years from the previous sale)- is used to determine your max exclusion under the partial rules. A ratio is determined. You might call it “prorating”. If the time period happens to be 12 months and you would have qualified for up to a $500,000 exclusion under a full exclusion, then instead your reduced limit is $250,000.

But that is IF you qualify for the partial exclusion. IF the main reason for your home sale was a change in workplace location, a health issue, or an unforeseeable event, then you might qualify. I say might because the rules are more detailed of course. For most service members and spouses one reason they might qualify for a partial exclusion is due to a Permanent Change of Station (PCS). Here are the basic rules for that:
1. The following applies to you or another owner of the property who was a resident:
2. You took a job or were transferred to a work location at least 50 miles further from your home than your previous work location, OR
3. You did not previously have a job and you took a job with a work location at least 50 miles from your home.

Most PCS moves do place the service member (and a spouse, if there is one) in the position that they can apply the partial exclusion.

While you can use IRS Pub 523 to guide you on this, please realize that the Publication doesn’t cover all scenarios and definitely doesn’t fully address partial exclusion situations. It is often best to consult section 121 directly, both in the tax code and in regulations. This is especially true for applying the partial exclusion generally. Both the partial exclusion for a health issue and an unforeseeable event has a lot of tax authority that is applicable that many folks often will have difficulty in applying properly. Also true of some change in work location situations. There is guidance that needs to be looked at in many situations in order to determine what the reason for the sale really was, particularly if there was a delay in selling. A safe harbor provision may apply in some cases. If the property was rented out after moving out then tax authority needs to be carefully referenced.

If you incorrectly apply the partial exclusion it can result in substantial penalties in addition to tax liability. If you are using IRS Pub 523 for guidance, I recommend stepping through the “full” or “regular” exclusion eligibility criteria before looking at the partial exclusion criteria. This provides you a better understanding of the criteria and makes it less likely you will make an error. It also helps you make sure that you don’t miss an exception that permits you to apply the full exclusion.

Please note that the portion of capital gains due to depreciation is subject to depreciation recapture. This means if there was depreciation (or effectively if you should have had depreciation) you will have tax liability due to that depreciation taken or what should have been taken. The capital gains exclusion for the sale of a primary home (Section 121 exclusion) does not apply to depreciation recapture.

Also note that state income tax codes, may or may not conform to the federal tax code, which is what this discussion has been directed towards.

If you would like help in filing a tax return with a partial exclusion, please consider one of our member tax professionals.