While this is an important topic for any taxpayer selling a home, it comes up frequently in military tax situations due to relatively frequent moving. On social media many well meaning folks will give you answers to this question that are incomplete at best and sometimes outright wrong. If you’ve asked this question on social media, most likely you have not provided enough information in your question so that someone can answer the question accurately and with certainty. 

The portion of the tax code we are addressing in this article is commonly called Section 121 and is regarding the exclusion of gain from sale of principal residence. IRS Pub 523 Selling Your Home can be helpful on this topic. Actually, for this article you need to also read IRS Pub 523 to get a decent picture of this topic. But it is important to remember that IRS Pub 523 does adequately address all situations on this topic. It may be necessary to consult additional sources, such as section 121 of the internal revenue code and federal regulations. In some cases further research is needed. But we’ll cover the “norm”, emphasizing key points which will help you if you read Pub 523 along with reading this article.  We are NOT talking about 1031 exchanges in this article. 

The maximum capital gains that can be excluded from taxation under section 121 is $250,000 for a taxpayer or $500,000 if filing a married filing joint return. Well, for one sale. It is important to note that this exclusion does not apply to the portion of gain that is due to depreciation recapture. If you were allowed to depreciate and you did not, depreciation recapture may still apply. 

You’ll hear folks talk about 2 out of 5 or 2 out 15 for the military or if you PCS that you can exclude capital gains due to the sale of a home from taxation. All that over-simplifies the actual requirements and can lead to incorrect conclusions. 

Another thing that many people often don’t really understand is how to determine capital gain on the sale of a home. It is very rarely the amount you walk away with. It does NOT include any loan principle as a factor. It is very rarely simply a matter of sale price minus buy price. There are other costs and other factors that may either increase or decrease the calculated capital gain. We aren’t covering the calculator of capital gains, I just want you to be aware that it isn’t what many people think it is. 

So assuming we have capital gains, aside from that due to depreciation, how do we determine if we can exclude it? Well I do recommend engaging a tax professional with the right experience and expertise. Those can be found here.  But for most DIY taxpayers or for those who don’t want to rely on their tax pro, I recommend stepping through the eligibility criteria for the exclusion in Pub 523 as your starting point. The eligibility test starts on page 3 and has six steps. If you determine that you don’t qualify for the full or normal exclusion, including by making use of any exceptions, then it often makes senses to follow through and determine if you qualify for a partial exclusion of gain and help with that determination starts on page 6.

Here are some key points about eligibility to remember as you step through the eligibility test. There are 6 steps for determining eligibility for the full or “regular” exclusion. Look in Pub 523 for details, but here we will emphasize some key points. Hopefully this list will dispel some confusion and myths. The line items below are NOT numbered to correspond to the steps. 

  1. We tend to talk about time requirements in years or months. 2 out 5 or 24 months for example. For section 121 when we say 2 years, we mean a full 2 years. As in 730 days. When we say 24 months, we don’t mean 23 months and 25 days. We mean a full 24 months. 
  2. Step 1 of the eligibility test does not apply for most taxpayers, but do read it and make sure it doesn’t apply to you. 
  3. For the 2 year ownership requirement, if filing jointly, only one spouse needs to meet this ownership test. 
  4. For the residence test, this is about living in the property as your principal residence. It doesn’t necessarily match your home of record or your state of legal residence. There can be absences, certain ones,  that don’t impact eligibility. 
  5. If you sold another home within 2 years prior to the sale of the home in question, then you are not eligible for the full or regular exclusion of capital gains. 
  6. Step 5 of the eligibility test covers exceptions to the eligibility tests. Details matter for these. Don’t just read what the exception is called when you think it applies to you. Instead dig into it and make sure it really does. The one we will spend some time, later in this article is what is often called “the military exception”, or the “military exclusion” or something similar. Those are misnomers and those misnomers alone lead to incorrect conclusions.
  7. Step 6 of the eligibility test, to paraphrase, indicates that if you have determined that you are eligible with the previous steps, then great, you are eligible for the full exclusion. But if those steps didn’t indicate you are eligible, then proceed with determining if you are eligible for the partial exclusion.

Let’s talk about the exception under step 5 of the eligibility test that is often used by service members. In my view this is best called the suspension of the running of the 5 year rule for ownership and residence for excluding the capital gains from taxation due to the sale of principal residence due to qualified official extended duty. But for some reason most people want to use terms like the military exclusion or the military exception instead. You can read about this in Pub 523, but here are some important points:

  1. You can suspend the running of the 5 year rule up to 10 years total for a property. This is how people get “2 of 15”, since 5 plus 10 is 15. Phrasing this as a suspension of the 5 year rule is important. Once the service member is not on qualified official extended duty, the 5 years start running again. It is possible, if you have 2 years of ownership and residency before going on qualified official extended duty (QOED) for up to 10 years, to have 3 more years before the full exclusion “runs out”. So you might have up to 3 years to sell and still make use of the exclusion. As soon as you are no longer on QOED, the suspension period is over. Suspension periods may be aggregated up to the 10 year total limit. You don’t have to be on QOED when you sell to make use of the exception for QOED. You don’t have to be on active duty at the time of the sale either (if you get a different idea from reading Pub 523, then now you know the downside of relying on IRS pubs and instructions vs. the tax code). 
  2. There are times in which if you have personal use of a property and rental or investment use, that you have to allocate gain between personal (qualified use: eligible for exclusion) and rental/investment (non qualified use: not eligible for exclusion under section 121). You don’t allocate gain to the time suspended under the exception for QOED as non qualified gain, meaning gain that is taxable. Instead when a service member qualifies for the exception for QOED they often (not always) do not have to pay any capital gains taxes on a sale, except for depreciation recapture.  Suspended time under this exception is qualified use for these gain allocation purposes. 
  3. You can only suspend the running of the 5 year rule due to QOED for ONE property at a time. This means that any generic advice to buy property at every duty station throughout a career and then later sell them all every 2 years and avoid all capital gains taxes should be viewed skeptically. Details matter, but in many cases following this advice would require filing incorrect tax returns to be successful. That can result in very severe repercussions. 
  4. People other than military members can have QOED. 
  5. Remember I mentioned gain allocation to qualified and non qualified use? If you have rental property use before the last time you lived in a property, then normally you may have to allocate gain as non qualified use and thus have gain that is taxable. Unfortunately, many tax professionals not familiar with the QOED exception misallocate gain to be taxable. However, there are cases where people own a property and have rental property use before personal use and that isn’t time suspended under the QOED exception. In those cases there may be gain allocated to non qualified use and thus be taxable gain, while some gain does qualify for the section 121 exclusion. Some situations require very careful navigation of section 121.

Let’s talk about the partial or reduced exclusion. Determining if you qualify for the partial exclusion starts on page 6 of IRS Pub 523-after you have determined you don’t meet the eligibility test for the full or “regular” exclusion. The most common way for qualifying for the partial exclusion is under the “work related move” reason. For the military, a military PCS often qualifies under the work related move reason, but eligibility should be verified of course. Here are some points regarding the partial exclusion. 

  1. There have been a lot of court cases regarding this area of the section 121 exclusion. If you are relying on a partial exclusion you want to be especially sure you get it right. Be very thorough in due diligence when claiming the partial exclusion.
  2. The second and the third way to qualify for the partial exclusion can often require very thorough diligence. These are for health related reasons and unforeseen circumstances.
  3. What you view as an unforeseen reason may not be what the IRS and tax authority view as qualifying unforeseen reason. Same with health related reasons.  
  4. If you are going to claim the partial exclusion for any reason, review not just Pub 523, but also the internal revenue code, federal regulations, and possibly court cases. 
  5. The partial exclusion lowers your limit for gain that can be excluded. In many cases, since it lowers the limit rather than only allowing you to exclude a percentage, it can be enough to exclude all capital gains (except for depreciation recapture). 
  6. The limit can be reduced based on how much time the taxpayer has that is less than 2 years for ownership, residence, or since the last time (sale date) section 121 was used to exclude gain. 
  7. It is possible to apply the partial exclusion not only within a two year period of another use of section 121, but also within the same year of a previous use. In theory there can even be multiple uses in a year.

 

I attempted to write this article in a way that you really need to consult IRS Pub 523 to get a decent understanding of this topic. So I hope I didn’t make it more confusing with that attempt. I hope this article helps, but since I know I didn’t cover it all, I will finish with a disclaimer. Every time I get the idea in my head that I’ve seen all the section 121 tax situations, that I won’t have to sort something new out, a taxpayer rises to the occasion and presents something that I have to do some diligent research to get the right answer. So the disclaimer is important. 

Disclaimer: This article does not cover all tax situations and is not tax advice for any individual’s specific tax situation. IRS Pub 523 is often not adequate in covering situations for which the exclusion of capital gains from taxation under section 121 may apply. Often with taxes you don’t know what you don’t know. Without detailed knowledge and diligence that can lead to incorrect conclusions. It is possible to read one IRS publication or one section of the tax code and come up with a different answer when comparing to another. This is why due dligence needs to be excercised to determine the correct answer. And this is why expertise and experience can be important. Also, federal income tax law may not always match up to how the state handles the same tax situation. This article just focuses on the federal tax code.